Greenhouse Gas Emissions Trading Schemes

RE 02

| KEI | 2005 | RE-02 | Authors

Yong Gun KIM

Greenhouse Gas Emissions Trading Schemes:

Korea Environment Institute is a government-funded research institute specializing in research and analysis oriented toward development of environmental policies and technology and professional assessment on environmental impact assessment statements. KEI will strive to become an internationally recognized environmental research institute of the 21st century, contributing to the prevention and resolution of environmental problems worldwide.

Recent Development and Policy Recommendations for Korea

Major Functions ■Research/development of environmental policies and environmental management techniques ■Reassessment of environmental policy implementations ■Research/development of environmental technology and promotion of cleaner production systems ■Development of policies and techniques for conservation of ecosystems ■Research on regional/global environmental issues, international environmental agreements, and environment-related trades ■Scientific assessments of environmental impact statements and prior environmental impact statements ■Development and dissemination of assessment techniques ■Distribution of environmental data/information and training, education, and public relations on environmental policies

2005

613-2 Bulgwang-Dong, Eunpyeong-Gu, Seoul, 122-706, Korea Tel 82-2-380-7777 Fax 82-2-380-7799 http://www.kei.re.kr

- Director - Climate Change / Policy Research Group

Erik F. HAITES - President

Greenhouse Gas Emissions Trading Schemes: Recent Development and Policy Recommendations for Korea Yong Gun KIM Erik F. HAITES

- Margaree Consultants

| KEI | 2005 | RE-02 |

Greenhouse Gas Emissions Trading Schemes: Recent Development and Policy Recommendations for Korea Yong Gun KIM Erik F. HAITES

Research Staff Leading Researcher: Yong- Gun Kim (KEI) Erik F. HAITES

Participating Researcher:

C 2005 by Korea Environment Institute Copyright ○

All rights reserved. No part of this publication may be reproduced or transmitted in any form or any means without permission in writing from the publisher Publisher: Suh Sung Yoon Published by: Korea Environment Institute 613-2 Bulgwang-Dong, Eunpyeong-Gu, Seoul, 122-706, Republic of Korea Tel.(822) 380-7777 Fax.(822) 380-7799 http://www.kei.re.kr Published and printed on: Dec. 2005 ISBN 89-8464-135-9 93530 Price ￦ 6,000

Foreword Climate change is one of the broadest and the most complex issues of international environmental cooperation. Concern about climate change has been steadily increasing and has become a worldwide issue. According to the IPCC’s third assessment report, global warming has accelerated more seriously than previously expected. The entry into force of the Kyoto Protocol in early 2005 demonstrates the firm resolution of the international community to address global warming. Emissions trading is considered a promising policy instrument for the cost-effective management of pollution. With the enforcement of the Kyoto Protocol, the frequency and volume of greenhouse gas emissions trading is increasing rapidly. More regions, countries, and sectors are expected to join the global carbon market in the coming years. Nevertheless, emissions trading faces many challenges. Despite the success stories, many problems have emerged. This study reviews and analyzes recent developments in greenhouse gas emissions trading schemes over the world and explores future policy directions for Korea based on the lessons from past experiences of other countries. I hope that this study will provide useful policy implications for the future development of a greenhouse gas emissions trading system in Korea and other countries. I would like to thank the authors, Yong Gun Kim and Erik F. Haites for their efforts and great work. Their dedication and hard work in resolving global environmental problems are highly commendable. I am also grateful to the following reviewers, Jong Soo Lim, Min Park, Dae Gyun Oh, and Yoon Yung Kang for their helpful comments and suggestions. Finally, I thank Jung Eun Kim and Sun Young Kim for editing the manuscript.

Suh Sung Yoon President Korea Environment Institute

Abstract

This study reviews and evaluates various GHG emissions trading schemes, including the Kyoto mechanisms, EU emissions trading scheme (ETS), United Kingdom ETS, the New South Wales trading scheme in Australia, and the ETS plans in Canada and the United States. Existing schemes, including CDM and EU ETS, show significant impacts on decision making in a wide range of areas to promote climate friendly investments and operations. In spite of the huge uncertainty of future climate policy, emissions trading is likely to play a major role. The experience and performance of GHG emissions trading in the past, however, reveals a lot of problems and challenges, including equity and efficiency issues related to initial allowance allocations, harmonization and the coordination of regional/national schemes, and the role of CDM in the global trading market. Based on a review and analysis of existing GHG emissions trading mechanisms, this study recommends a framework for GHG emissions trading in Korea. A phased approach is required to meet the unique policy environment of Korea: A voluntary emissions trading scheme in the pre-commitment stage, and a mandatory cap-and-trade scheme in the commitment stage. For a mandatory GHG cap-and-trade scheme, the best way to allocate allowances seems to be an auction combined with revenue recycling to the participants. An auction avoids a lot of potential problems including baseline protection, compensation for early action, adverse selection, windfall profits to incumbents, entry barriers, negotiation complexity and many other equity and efficiency issues. In the pre-commitment stage, CDM can be utilized as a key driving force for developing countries to introduce a GHG emissions trading scheme. An incentive auction can be proposed as a potential CDM project. Considering the existing air pollutant cap-and-trade policy of Korea, a multi-pollutant cap-and-trade system, covering GHG and conventional air pollutants, for the Seoul Metropolitan Area may be a promising option for cost-effective GHG emissions trading in Korea. Such a multi-pollutant trading scheme also can be applied for a unilateral policy-based CDM. The regulation

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on mandatory reporting and disclosure of corporate GHG emissions is also a useful initial step towards successful implementation of emissions trading. Several policy implications are also suggested for the future development of emissions trading for conventional air pollutants in Korea, which is planned to start in 2007.

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Contents Abstract .................................................................................................................. i Contents ................................................................................................................iii List of Tables ......................................................................................................... iv List of Figures ......................................................................................................... v Chapter 1. Introduction ......................................................................................1 1. Background and Objectives ......................................................................1 2. Recent Developments in Climate Change Negotiations.......................2 Chapter 2. Greenhouse Gas Emissions Trading Schemes ..........................9 1. Kyoto Mechanisms .....................................................................................9 2. European Union Emissions Trading Scheme .......................................16 3. United Kingdom Emissions Trading Scheme ......................................21 4. Australia.....................................................................................................26 4.1

The NSW Greenhouse Gas Abatement Scheme...........................26

4.2

National Emissions Trading Taskforce ..........................................28

5. Large Final Emitter and Offset Systems of Canada.............................29 6. United States .............................................................................................33 6.1

The Regional Greenhouse Gas Initiative........................................33

6.2

Massachusetts and New Hampshire..............................................35

7. Japanese Voluntary Emissions Trading Scheme..................................36 7.1

Climate Change Policy ......................................................................36

7.2

Japanese Voluntary Emissions Trading Scheme (JVETS)...........37

7.3

Evaluation............................................................................................39

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Chapter 3. Evaluation and Policy Implications ...........................................43 1. Initial Allocation of Allowances .............................................................43 2. Linkage.......................................................................................................52 3. Early Action, Banking and Penalty ........................................................54 4. Treatment of Closures and New Entrants.............................................57 Chapter 4. A Framework for Emissions Trading in Korea...........................65 1. Policy Environment of Korea..................................................................65 1.1

Greenhouse Gas Emissions ..............................................................65

1.2.

Development of Greenhouse Gas Emissions Trading ...............66

1.3

Air Pollutant Emissions Trading in Seoul Metropolitan Area...68

2. Policy Recommendations for GHG Emissions Trading in Korea..............74 2.1

A Phased Approach...........................................................................74

2.2

Commitment Stage ............................................................................75

2.3

Pre-Commitment Stage.....................................................................77

Chapter 5. Concluding Remarks.....................................................................88 References ..............................................................................................................93 Abstract in Korean................................................................................................97

List of Tables Table 2-1. Annual Volumes of Project-Based Emissions Reductions Traded ................................................................................................................15 Table 2-2. The main elements of the EU emissions trading scheme (EU ETS) ................................................................................................................16 Table 2-3. Summary of EU ETS Phase I Allocation Plans................................19 Table 2-4. Comparison of direct participants and CCA sectors of the UK ETS .........................................................................................................22

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Table 2-5. Key elements of the direct participant and CCA components of the UK ETS ...........................................................................................22 Table 2-6. Operation of the NSW Greenhouse Gas Abatement Scheme .......28 Table 2-7. Initial Emission Caps by State ...........................................................34 Table 3-1. Allocations Under Existing Cap-and-Trade Programmes ............45 Table 4-1. Major indicators of Greenhouse Gas Emissions .............................66 Table 4-2. Proposals for Pilot Phase GHG Emissions Trading for Korea .....67 Table 4-3. Number of firms and emission quantities (kg/year) by industry classifications in Seoul Metropolitan Area ......................................80

List of Figures Figure 2-1. EUA 2005 Prices .................................................................................20 Figure 3-1. Evaluation of EU ETS Phase I allocation plans .............................48 Figure 3-2. Equilibrium Outcome of Incentive Auction under Cost Uncertainty ........................................................................................51 Figure 4-1. Number of Firms and Cumulative Emissions...............................83 Figure 4-2. Diagrammatic Explanation of Intensity Regulation under Emissions Trading ............................................................................84

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Chapter 1. Introduction

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1. Background and Objectives Concern about climate change has been steadily increasing and has become a worldwide issue. According to the IPCC’s third assessment report, global warming has accelerated more seriously than previously expected. The entry into force of the Kyoto Protocol in early 2005 demonstrates the firm resolution of the international community to address global warming. Emissions trading is considered a promising policy instrument for the cost-effective management of pollution. It has been applied to sulfur dioxide and nitric oxides control in the United States for a decade and now is becoming a major instrument for controlling greenhouse gases internationally and domestically. The European Union started a mandatory emissions trading programme this year to reduce carbon dioxide emissions. With the entry into force of the Kyoto Protocol, the frequency and volume of greenhouse gas emissions trading is increasing rapidly. More regions, countries, and sectors are expected to join the global carbon market in the coming years. Nevertheless, emissions trading faces many challenges. Despite the success stories, many problems have emerged. Moral hazard and adverse selection have been difficult problems to overcome. How to link trading regimes covering different regions or countries, and different pollutants -- greenhouse gases and conventional air pollutants -- is a challenge. How to design a global carbon market with both developed and developing countries in a single coherent system to get the maximum benefit of emissions trading is an important issue. The objective of this study is to review, analyze, and evaluate greenhouse gas emissions trading schemes and related market activities, and to make policy suggestions for future development, with a recommendation on the framework for a future greenhouse gas trading scheme for Korea.

Greenhouse Gas Emissions Trading Schemes: Recent Developments and Policy Recommendations for Korea

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The scope of the study includes: -

to review the recent trends of climate change negotiations

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to review greenhouse gas emissions trading schemes, including the Kyoto mechanisms and EU emissions trading scheme, and to analyze the greenhouse gas emissions markets

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to evaluate the greenhouse gas emissions trading schemes and derive policy implications for future programmes

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to make policy recommendations on the framework for greenhouse gas emissions trading for Korea.

2. Recent Developments in Climate Change Negotiations International negotiations on climate change mitigation policy span more than a decade and there are many achievements together with many challenges that remain to be addressed. Of the many achievements of international climate change policy, three appear to be particularly significant. First, the United Nations Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol have created a solid institutional basis for the negotiating process, including establishment of the principles, setting an objective, and instituting decision-making procedures that allow the international climate change regime to evolve. Second, the Kyoto Protocol incorporates quantified emission targets for industrialized countries that appear, despite a number of shortcomings, to be an important element of the way forward. 1 Third, the establishment of three trading mechanisms for meeting mitigation obligations should reduce the cost of meeting the regime’s emissions limitation commitments and thus strengthen the forces that drive climate protection2 (Oberthur and Ott, 2004). With Russian ratification, the 1

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Under both the Convention and the Kyoto Protocol, only industrialized countries (Annex I Parties) are subject to emission caps. The Convention requires Annex I Parties to take policies and measures with the aim of returning their emissions of carbon dioxide and other greenhouse gases to their 1990 levels by 2000. Most of the Annex I Parties did not achieve this target. The Kyoto Protocol strengthens the Convention by setting individual, legally binding caps on the emissions of Annex I Parties. Each Annex I Party must reduce its emissions or, in some cases, limit its emissions growth from 1990 levels for the 2008~2012 commitment period. The Kyoto Protocol establishes three emissions trading mechanisms: emissions trading between


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Kyoto Protocol finally entered into force on February 16, 2005, with the participation of more than 130 countries including about 35 Annex I countries.3 In spite of these achievements, the international climate change regime faces significant challenges. There are many serious problems including the lack of long-term targets and timetables, the limited participation in emission reduction commitments, and the high uncertainty of international policies, particularly after 2012. The emissions limitation commitments by industrialized countries under the Kyoto Protocol are not enough to prevent dangerous anthropogenic interference with the climate system.4 US withdrawal made things worse. The emissions limitation commitments of the Annex I Parties to the Protocol could allow their aggregate 2008~2012 emissions to increase. This is because the surplus allocations to Russia and other eastern European countries may be large enough to meet the entire demand for emission reductions in the other industrialized country Parties to the Protocol.5 Without the active participation of major countries, including the United States, China and India, any international climate regime may not be effective enough to mitigate climate change problem. Wide participation, together with establishing long-term targets, is an essential element of a successful future climate change regime. Negotiation of post-2012 commitments is expected to

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industrialized countries (Article 17), Jjoint Iimplementation of projects by two industrialized countries to achieve additional emission reductions (Article 6), and Joint Implementation of projects by developing and industrialized countries in the framework of the Clean Development Mechanism (Article 12). All three mechanisms allow industrialized countries with high abatement costs to acquire cheaper emission credits abroad. As a result, the overall costs of meeting the emissions limitation commitments of Annex I Parties to the Protocol are reduced. According to Article 25 of the Kyoto Protocol, it shall enter into force on the ninetieth day after the date on which not less than 55 Parties to the Convention, incorporating Parties included in Annex I which accounted in total for at least 55 percent of the total carbon dioxide emissions for 1990 of the Parties included in Annex I, have deposited their instruments of ratification, acceptance, approval or accession. Russia, which accounts for 17 percent of carbon dioxide emissions of Annex I countries in 1990, became the key to the entry into force of the Protocol after the United States, which accounts for 36 percent of Annex I emissions, pulled out of the Protocol. The ultimate objective of the Convention is to stabilize greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system. This concentration level has not yet been agreed, but to stabilize the atmospheric concentration of greenhouse gases at any level will require significant reductions from current global emissions. In Russia and several other eastern European countries the emissions limitation commitment is higher than the projected emissions for 2008~2013 due to the significant economic declines they experienced during the early 1990s. In principle, the surplus allowances can be sold to other Annex I Parties and be used by them to meet their commitments. The difference between the emissions limitation commitment and the projected business as usual emissions is often called ‘hot air’.

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deal with this issue in the coming years.6 Many proposals and studies of future emission limitation commitments have been published over the past several years.7 Some proposals emphasize the advantage of absolute emission caps as under the Kyoto Protocol and suggest extending such commitments to developing countries and some proposals favor more flexible and voluntary approaches such as non-binding intensity targets, sectoral CDM or even sustainable development policies and measures for developing countries. There also have been many studies on the differentiation of commitments among countries with various principles for burden sharing. The first chance to deal with the future commitment issue was the Seminar of Governmental Experts held on 16 and 17 May 2005 in Bonn, Germany.8 The decision to hold a Seminar was taken by Parties at the Tenth Conference of the Parties (COP-10) to the UNFCCC in December 2004. The Seminar sought to address the question of how to engage on some of the broader issues facing the climate change process. Foremost among these for some Parties was the question of a future framework and commitments to combat climate change in the post-2012 period. There was also some interest in other issues, such as how to respond to the increasingly strong evidence of climate change, address the differences of opinion over Kyoto, and move forward in dealing both with climate change mitigation and adaptation.9 6

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The Convention and the Kyoto Protocol both include clauses that could be invoked to launch a new negotiating round. The review under Article 4.2(d) of the Convention that led to the negotiation on the Kyoto Protocol was not a one-off event. Article 4.2(d) in fact called for a second review by December 31, 1998, and thereafter at regular intervals. Industrialized and developing countries, however, disagreed over the scope of the second review, generating a deadlock. While industrialized countries wanted to discuss a process for extending emission controls to non-Annex I Parties, developing countries preferred to review the implementation of existing Annex I emission targets. This review process remains “on hold” on the provisional agenda of the COP; despite its tortuous history, it may still provide an opportunity to launch a negotiation on the future of the regime. Article 3.9 of the Kyoto Protocol calls on the COP/MOP to launch negotiations on targets for Annex I Parties for the Protocol’s second commitment period by 2005. Article 9, in turn, provides for a more general review of the Protocol. This general review is not confined to the commitments of Annex I Parties and therefore could be used to launch a new negotiating round that would also cover non-Annex I emission controls. (Depledge, 2002) Refer to Bodansky (2004) for a comprehensive survey of approaches on future commitments. Refer to IISD (2005) for detailed information on this. The issue of a post-2012 framework proved to be particularly sensitive at COP-10. While the Kyoto Protocol requires Parties to begin considering the post-2012 period by 2005, many developing countries have objected in the past to attempts to expand the group of nations that have binding emissions targets from Annex I Parties into the ranks of the Group of 77 and China (G-77/China). Developing countries argue that industrialized countries should take the lead, based on the principle of common but differentiated responsibilities. There was also the question of how to include non-Parties to Kyoto in talks on subsequent commitments. As a result of these concerns, the terms of reference for the Seminar were kept broad and general, with no specific reference to a


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There was considerable discussion of national circumstances, and many observers noted a desire to understand other Parties’ positions and preoccupations. As well as the “user-friendly” organizational style, many observers were also pleased with the substantive nature of the discussions, noting the focus on issues rather than procedure. Controversial issues were discussed openly. These included free-flowing debates on technology transfer, the benefits and shortcomings of the CDM, adaptation and mitigation, and even nuclear energy. Discussions about technology played an important role in the Seminar. On technology transfer issues, developing nations articulated a clear desire for a greater commitment on this issue on the part of industrialized countries. Participants generally saw the CDM as a positive and innovative contribution, but they also recognized the need to review and streamline the procedures and expand the mechanism’s scope. They also focused attention on the need to develop new technologies. Some observers detected a greater willingness to engage on technology issues that the United States and some other countries have focused on recently, including carbon sequestration and ”clean” fossil fuels. Many experts emphasized the financial aspects of addressing climate change, especially the need to ensure that actions provide economic opportunities and are cost-effective. Again, some felt this reflected a desire to accommodate the perspectives of those who had criticized Kyoto on economic grounds. Business and industry’s desire for long-term certainty was stressed repeatedly, as were companies’ concerns about their inability to plan properly with the post-2012 framework still so unclear. There appeared to be consensus that such uncertainty was bad for long-term investment. Many Parties also stressed the increasing evidence on the economic impacts of climate change, which several participants felt contributed to the more open dialogue at the Seminar. In particular, recent meetings affirming the dangers of allowing temperatures to rise more than 2˚ C above pre-industrial levels seemed to have strengthened many Parties’ conviction that urgent action is needed. Another message from the Seminar was the long time-lag for translating post-2012 framework or other controversial matters. Parties at COP-10 agreed that the Seminar should encourage an“ informal exchange of information on: (a) actions relating to mitigation and adaptation to assist Parties to continue to develop effective and appropriate responses to climate change; and (b) policies and measures adopted by their respective governments that support implementation of their existing commitments.”


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political decisions into effective policy. This view seemed to inspire a greater openness to talking about the post-2012 period. Some Parties clearly hoped for a ”Montreal Mandate” from COP/MOP-1 that would lay out a roadmap for the post-2012 negotiation phase. Whether that road makes its way directly through Kyoto territory, within the UNFCCC framework, or heads down several different paths, was a question most Parties were careful to avoid. Another important meeting related to the development of international climate change regime was the 17th OECD Round Table on Sustainable Development held on 1 and 2 June 2005 in Paris, France.10 The Round Table had a discussion based on a background paper on transnational sectoral agreements. The meeting heard presentations on five key illustrative sectors – aluminum, cement, steel, and power generation from coal and automobiles. The presentations focused on the structure of each industry, its contribution to overall greenhouse gas emissions and future possibilities. The potential and difficulties posed by transnational sectoral agreements were discussed with four key questions: -

Who would be the parties to an agreement, and what would be the relative roles of governments and businesses?

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What would be the incentive to take part in an agreement to reduce emissions intensity – particularly if you were a company in a developing country?

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What information would be needed to make an intensity-based agreement work?

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Are there any areas where R&D cooperation would make sense and again, what would be the respective roles of governments and businesses?

The meeting explored the ‘framework conditions’ that might be needed to permit the successful negotiation of a transnational sectoral agreement (TSA) in each of the chosen sectors. It was acknowledged that understanding the incentives for industry, developing countries and developed countries would be important to negotiating any agreement. There was general agreement that a TSA would need to: 10

Be compatible with existing institutions and mechanisms such as the

For more information on this meeting, refer to ‘Chairman’s summary note of the 1-2 June 2005 meeting of the Round Table on Sustainable Development,’ OECD, SG/SD/RT(2005)2.


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Kyoto Protocol, emissions trading and CDM, benefit from lessons learned and in no way prejudice the negotiating position of countries under the UNFCCC. -

Bring together a critical mass of companies.

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Have sufficient country coverage.

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Create a level playing field globally to ensure that national policies were not distortionary.

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Be environmentally meaningful and credible.

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Recognize the development goals of developing countries.

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Promote R&D.

There was broad agreement that governments do have a role to play in the setting up of any TSAs. Possible roles for government are incorporating TSAs into national targets, linking TSAs and any trading under them to other emissions trading schemes, providing administrative and technical assistance to industry, providing assistance with data gathering, and facilitating better technology transfer through CDM reform. On the issue of developing country engagement, it was agreed that little incentive currently exists. A credible threat of future government regulation would be required to attract business engagement. It was agreed that the key challenge at the current time is how the CDM can be scaled up to the point where it can make a significant impact on emissions. It was accepted that more projects are needed in key sectors where current investment programmes will significantly influence emissions levels for the next 25 years. The significant gap between R&D needs and funding was explored. The urgent need for more public investment in carbon capture and storage capacity was stressed. The lack of mechanisms for the creation of collective R&D was identified as an area requiring action. OECD and others have also been exploring options for sectoral approaches. Bosi and Ellis (2005) investigate a range of sectoral crediting mechanisms, including policy-based crediting, rate-based (indexed) crediting and fixed sectoral emission limits, in terms of trans-national or national approaches. The development of sectoral approaches incorporating the CDM seems to be plausible in the near future as a means to engage developing countries in global climate change mitigation efforts. The design of such sectoral mechanisms may affect the international market

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for GHG emissions trading significantly, as well as how to proceed on developed countries commitments after 2012. Another trend that could have great significance for GHG emissions trading is efforts to link Kyoto Parties and Non-Parties. Several initiatives on GHG emissions trading from the United States and Australia consider linking their market to the Kyoto market. The Kyoto Parties, such as the EU, are expected to accept linking arrangements with other Kyoto Parties and may consider links with Non-Parties.11 Although it is too difficult to anticipate the result of international negotiations on future commitments, GHG emissions trading is almost certain to be part of the future. It is also highly likely that the GHG market may evolve into a coherent global market in the long term, even though it may start with several diverse and fragmented markets. In near future, there will be many domestic or regional GHG markets coexisting with the international Kyoto market. In the middle to long term there will be tremendous efforts to link and harmonize, together with hard coordination and negotiation on international emission limitation commitments.

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See Chapter 2 for detailed information on linking provisions.

Chapter 2. Greenhouse Gas Emissions Trading Schemes

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Chapter 2. Greenhouse Gas Emissions Trading Schemes

1. Kyoto Mechanisms The Kyoto Protocol to the United Nations Framework Convention on Climate Change establishes emission limitation commitments for 2008~2012 for developed countries (Annex B Parties) that ratify the Protocol. 12 Each Annex B Party will issue Assigned Amount Units (AAUs) equal to its emissions limitation commitment and issue Removal Units (RMUs) for internationally approved increases in designated carbon sinks. In addition to domestic emission reductions and sink enhancements, an Annex B Party can meet its commitment through emission reductions or increases in carbon sinks in other countries. Such actions lead to the creation and transfer of other units (ERUs, CERs, tCERs or lCERs). To comply with its emission limitation commitment, an Annex B Party must hold Kyoto units (AAUs, ERUs, CERs, tCER,s lCERs or RMUs) equal to its actual emissions during the 2008~2012 period. The Protocol includes three mechanisms through which an Annex B Party can encourage emission reductions or increases in carbon sinks in other countries. All three mechanisms can be used by Annex B governments to help meet their national commitments. All of the mechanisms also allow the participation of private entities under the supervision of the relevant government. Entities covered by domestic emissions trading programmes in Annex B countries are likely to be allowed to use Kyoto units for compliance and so may wish to use the mechanisms. The three mechanisms are:

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The emission limitation commitments of 38 countries (plus the European Community), expressed as a fraction of each country's base year (usually 1990) emissions, are listed in Annex B to the Protocol. Hence, a country with an emission limitation commitment that ratifies the Protocol is called an Annex B Party. Developing countries do not have emission limitation commitments. A developing country that ratifies the Protocol is called a non-Annex B Party.

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z Article 6: Joint Implementation (JI): A project to mitigate climate change -- reduce emissions or enhance specified sinks of greenhouse gases -- in an Annex B Party can earn Emission Reduction Units (ERUs) that can be used by another Annex B Party to help meet its emission limitation commitment. This reduces the net emissions of the host country and allows higher emissions in the country that acquires the ERUs. Joint Implementation projects and the associated emission reductions or increases in carbon sinks can be approved in one of two ways. An international process, similar to that for the Clean Development Mechanism (discussed below), will be established by a JI Supervisory Committee. Annex B Parties that meet specified criteria may establish a domestic process. A project in a country with a domestic process could choose either the domestic or international approval process. 13 Joint Implementation projects can begin to earn ERUs only in 2008, so the international process is not yet operational. Several governments and funds have entered into contracts to purchase ERUs. Those contracts typically require the host government to indicate that it will approve the project as a JI project. These countries then have criteria for JI projects, but most of them have not yet established a formal review and approval process. To issue an ERU the host government, an Annex B Party, converts an AAU by adding relevant codes. If the reductions achieved by the JI project are less than the ERUs issued (AAUs converted), compliance with the country's emission limitation commitment becomes more difficult. Thus the host Party has an incentive to ensure that JI projects achieve the emission reductions or sink increases claimed.

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Article 12: Clean Development Mechanism (CDM): A project to mitigate climate change in a non-Annex B Party can generate certified emission reductions (CERs, tCERs or lCERs) that can be used by an Annex B Party to help meet its emission limitation commitment. To ensure that the projects achieve the emission reductions or increases in carbon stocks

Buyers may believe that the international process is better known and so may prefer projects approved under that process. A project developer might choose the international process to reduce the risk that ERUs could not be issued if the host government loses its eligibility to implement a domestic process during the life of the project. Since all projects require the approval of the host government, it could require projects to use the domestic process.

Chapter 2. Greenhouse Gas Emissions Trading Schemes 11

claimed, they must use methodologies approved by the CDM Executive Board and have the claims certified by an accredited expert. An emission reduction project reduces the net emissions of the host country and allows higher emissions in the country that acquires the resulting CERs. Afforestation or reforestation of lands that were vacant on January 1, 1990 is also allowed. Since the carbon stored by the trees and soil can be released again by disease, fire, harvesting or other events, special provisions are included to address the non-permanence of these projects. The non-permanence provisions result in the issuance of units, tCERs or lCERs, with limited lifetimes.

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Article 17: International Emissions Trading (IET): One Annex B Party can transfer some of its allowable emissions, assigned amount units (AAUs), or acquired ERUs, CERs and Removal Units (RMUs), to another Annex B Party. This increases the allowable emissions in the recipient country and reduces those of the seller country. Many Annex B Parties are establishing domestic greenhouse gas emissions trading programmes for designated industrial sources. These programmes establish limits on the aggregate greenhouse gas emissions by the designated sources. Allowances equal to the aggregate emissions are distributed. The allowances are usually distributed free to the trading programme participants, but some allowances may also be auctioned. Each participant must measure its actual emissions and submit allowances equal to its actual emissions to the regulatory authority. Participants can buy or sell allowances to ensure that they have enough to cover their actual emissions. Participants generally are also allowed to use Kyoto units for compliance purposes. Participants in the EU Emissions Trading Scheme are permitted to exchange CERs and ERUs for EU allowances, which they can then use for domestic compliance. The EU allowances can be freely traded across all countries (at least the 25 EU Member States) participating in the scheme. From 2008 onwards, this means that the international trade of EU allowances must be matched by transfers of AAUs so that the compliance strategies adopted by participating establishments do not adversely affect national compliance efforts.


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The mechanism of interest to developing countries is the Clean Development Mechanism. Detailed rules for emission reduction projects under the CDM were agreed in November 2001 as part of the Marrakech Accords. Members of the Executive Board, which administers the CDM, were elected at that time. Rules for afforestation and reforestation projects under the CDM were adopted in December 2003. An emission reduction project under the CDM must: -

use an approved methodology to define the baseline emissions -- the emissions that would have occurred in the absence of the project -- from which reductions are calculated;

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use an approved monitoring methodology to monitor actual emissions and collect other information needed to calculate the emission reductions achieved; and

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be reviewed by an accredited ”operational entity” which confirms that the proposed baseline and monitoring methodologies are appropriate and that other eligibility requirements are met.

The Executive Board has prepared simplified baseline and monitoring methodologies for 13 categories of small-scale CDM projects. Small-scale CDM projects are: -

Renewable energy project activities with a maximum output capacity equivalent of up to 15 megawatts (or an appropriate equivalent);

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Energy efficiency improvement project activities which reduce energy consumption, on the supply and/or demand side, by up to the equivalent of 15 gigawatt/hours per year;

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Other project activities that both reduce anthropogenic emissions by sources and directly emit less than 15 kilotonnes of carbon dioxide equivalent annually.

Private and/or public entities may implement CDM projects. The host government must approve the project. The Annex B Party using the CERs toward its commitment must also approve the project. Official development assistance (ODA) may not be used to help finance CDM projects. Projects may


choose a single crediting period of ten years or a renewable crediting period of seven years with up to two renewals for a total of 21 years.14 The baseline must be revised as appropriate for each renewal. Some of the CERs earned go to the Executive Board for administrative expenses and to contribute to an adaptation assistance fund. The rules for afforestation and reforestation projects under the CDM are identical to those for emission reduction projects with a few exceptions. The projects must be implemented on land that was not forested on 1 January 1990. The projects may choose a single crediting period of 30 years or a renewable crediting period of 20 years with up to two renewals for a total of 60 years. The project proponents must choose one of the two options to address non-permanence leading to the issuance of tCERs or lCERs. Both of these units expire at specified times and then must be replaced. An Annex B Party may only use tCERs and lCERs equal to 5% of its base year (usually 1990) emissions for compliance during the first commitment period. Small-scale afforestation and reforestation projects under the CDM are those that are expected to result in net removals by sinks of less than 8 kilotonnes of CO2 per year and are developed or implemented by low-income communities and individuals as determined by the host Party. If a small-scale afforestation or reforestation project results in net removals greater than 8 kilotonnes of CO2 per year, the excess removals will not be eligible for the issuance of tCERs or lCERs. Eligible CDM projects can generate CERs, tCERs, or lCERs from January 1, 2000. Most of the transactions involving the Kyoto mechanisms are related to CDM because it is the only mechanism that was operational before 2008.15 According to IETA and the World Bank (2005), the total volume exchanged through project-based transactions in 2004 was 107 MtCO2e, a 38% increase relative to 2003. About 43 MtCO2e have been exchanged during the first four months of 2005, suggesting that the market for project-based transactions continues to grow, albeit at a slower pace than during the period 2001-2003. In the past 12 months, the number of JI and CDM projects under development has also increased substantially, with notably a large supply of unilateral CDM 14 15

The crediting period is the period during which a CDM project can earn CERs for the emission reductions or sink increases achieved. Firms and governments can enter into contracts to buy or sell AAUs, ERUs or RMUs even though those units do not yet exist. These “forward contracts” specify the price, payment terms, and other conditions for future delivery of the contracted units.

14


projects. Table 2-1 shows that compliance with regulatory regimes is by far the main driver of purchases of project-based units, most of which are CERs.


Table 2-1. Annual Volumes of Project-Based Emissions Reductions Traded

1998 1999 2000 2001 2002 2003 2004 2005 (Jan-April) Total

Total Project-Based Transactions

Compliance

Voluntary

Retail*

17,976,538 35,423,491 17,094,425 13,004,103 28,776,967 77,641,815 107,010,089

0 0 387,933 4,724,591 14,676,748 70,429,780 104,600,758

17,907,448 35,265,724 16,507,407 8,161,652 13,893,209 6,773,367 2,299,050

69,090 157,767 199,085 117,860 207,010 438,669 110,281

42,863,095

39,823,182

2,995,000

44,913

339,790,524

234,642,992

103,802,856

1,344,675

Note: All volumes are for vintages up to 2012 only. Data for retail incomplete. Source. IETA and World Bank (2005)

European buyers represent the bulk of the purchases of emission reductions, with a combined 60% of total volume purchased between January 2004 and April 2005, compared with 21% for private and public entities in Japan and 4% for private entities in Canada. The supply of emission reductions has remained heavily concentrated in a few countries: notably India (by far the largest supplier of project-based ERs on the market), Brazil and Chile. HFC23 destruction is still the dominant type of emission reduction project in terms of volume supplied (25% from January 2004 to April 2005). Projects capturing methane and N2O from animal waste now rank second (18%), ahead of hydro, biomass energy and landfill gas capture (about 11% each). Projects abating non-CO2 emissions account for more than half of the total volume supplied, while traditional energy efficiency or fuel switching projects, which were initially expected to represent the bulk of the CDM, account for less than 5%. Due to the heterogeneity of the underlying projects and contracts terms, the spread of prices for project-based emission reductions at any given time is very large. Certified Emission Reductions have traded between $3 and $7.15/tCO2e between January 2004 and April 2005.

16


2. European Union Emissions Trading Scheme The EU ETS is a ‘cap-and-trade’ scheme, along the lines of the US Acid Rain Programme. The estimated 12,000+ participants in the scheme include electricity generators, oil refineries and energy intensive manufacturing installations in sectors such as iron and steel, paper and minerals. Each participant is allocated a number of allowances each year as specified in the country’s national allocation plan approved by the European Commission. On the 30th of April each year, each participant is required to surrender a quantity of allowances equal to its emissions in the preceding calendar year. Participants with high abatement costs will be able to cover their emissions by purchasing additional allowances, while those with low abatement costs will be able to reduce emissions and sell their surplus allowances for a profit. Estimates made on behalf of the Commission suggest that the scheme will reduce total abatement costs by 24%, leading to cost savings of €2.1billion/year by 2010 (Capros and Mantzos, 2000). The main features of the scheme are summarized in Table 2-2.

Table 2-2. The main elements of the EU emissions trading scheme (EU ETS) Compliance periods

Phase 1: 2005~2007 Phase 2: 2008~2012 (i.e. the first Kyoto Protocol commitment period).

Type of Target

Absolute targets

Allocation of allowances

Phase 1: A minimum of 95% of allowances to be allocated free of charge Phase 2: A minimum of 90% of allowances to be allocated free of charge National allocation plans are subject to approval by the Commission and must be based on objective and transparent criteria, including those set out in Annex III of the Directive


Sectors included

All combustion plants >20MW thermal input, including electricity generators, oil refineries, coke ovens, ferrous metals, cement (>500 tonnes/day), paper and pulp, brick, glass and ceramics (> 20 tonnes/day). Based upon the coverage of the IPPC Directive, but some IPPC sectors are excluded (e.g., food and drink, waste incineration, chemicals). Sites below IPPC size thresholds in eligible sectors may also be included.

Size of market

>12000 installations >=45% of all EU carbon dioxide emissions

Basis

Phase 1: only direct CO2 emissions Phase 2: other gases may be included, provided adequate monitoring and reporting systems are available and provided there is no damage to environmental integrity or distortion to competition

Links with JI/CDM

‘Linking’ Directive allows credits from CDM and JI projects to be recognised from 2005 and 2008 respectively. The quantity of CDM and JI credits used may be capped during Phase 2.

Links with other countries’ schemes

Agreements with other parties listed in Annex B of the Kyoto Protocol may provide for mutual recognition of allowances between the EU ETS and other schemes

Monitoring, Reporting and Verification

Common monitoring, verification and reporting obligations. Verification through third-party or government authority.

Allowance tracking

Linked/harmonised national registries with independent transaction log.

Sanctions

Phase 1: 40 €/tCO2 penalty + loss of allowances equal to excess emissions in the subsequent year Phase 2: 100 €/tCO2 penalty + loss of allowances equal to excess emissions in the subsequent year

Banking

Banking across years within Phase 1 and Phase 2 Member States determine the rules for banking from Phase 1 to Phase 2. Very restricted banking allowed by two countries.

Phase 1 of the EU ETS commenced on 1 January 2005 and continues

18


through 31 December 2007. Phase 2 of the scheme coincides with the first Kyoto commitment period and is likely to involve a larger number of participants from a wider range of sectors. Subsequent phases cover five year intervals.


Table 2-3. Summary of EU ETS Phase I Allocation Plans

Member State Austria Belgium Czech Republic Cyprus Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Slovak Republic Slovenia Spain Sweden United Kingdom Total Note:

CO2 allowances in mio. tonnes

Share in EU allowance

Installations covered

Registry functional

Kyoto target

99.0 188.8 292.8 16.98 100.5 56.85 136.5 469.5 1,497.0 232.2 93.8 67.0 697.5 13.7 36.8 10.07 8.83 285.9 717.3 114.5

1.5% 2.9% 4.4% 0.3% 1.5% 0.9% 2.1% 7.1% 22.8% 3.4% 1.4% 1.0% 10.6% 0.2% 0.6% 0.2% 0.1% 4.3% 10.9% 1.7%

205 363 435 13 378 43 535 1,172 1,849 141 261 143 1,240 95 93 19 2 333 1,166 239

Yes No No No Yes No Yes Yes Yes No No No No No No No No Yes No No

-13%* -7.5%* -8% -21%* -8% 0%* 0%* -21%* +25% -6% +13%* -6.5% -8% -8% -28%* -6%* -6% +27%*

91.5

1.4%

209

No

-8%

26.3 523.3 68.7

0.4% 8.0% 1.1%

98 819 499

No Yes Yes

-8% +15% +4%*

736.0

11.2%

1,078

Yes

-12.5%*

6,572.4

100%

11,428

Figures do not take into account any opt-ins and opt-outs of installations in accordance with Articles 24 and 27 of Directive 2003/87/EC. The national allocation plans of some countries have not yet been approved by the Commission, so the number of installations and allowances will change somewhat. * Under the Kyoto Protocol, the EU15 has to reduce its collective greenhouse gas emissions by 8% below 1990 levels during 2008-2012. This target is shared among the 15 Member States under a legally binding burden-sharing agreement (Council Decision 2002/358/EC of 25 April 2002). The Member States that joined the EU on 1 May 2004 have individual targets under the Kyoto Protocol with the exception of Cyprus and Malta, which have no targets. ** All countries are required to have a registry and it is expected that all will have a functional registry

20


by April 2006. Source. European Commission, Reproduced from Point Carbon (2005)

Source. PointCarbon (2005)

Figure 2-1. EUA 2005 Prices

As early as 2003, some companies started engaging in demonstration trades of EUAs in anticipation of entry into force of the EU ETS. All such transactions were forward trades. The volume exchanged through these early trades increased steadily, from an estimated 650,000 tCO2e in 2003 to about 9 MtCO2e in 2004. Since January 2005, the volume exchanged on the market has increased dramatically to average almost 2 million tCO2e per day in September 2005. (Point Carbon, Carbon Market Europe, September 16, 2005 reports trades of 9.6 million EUAs during the week). In addition to forward trades, the market now includes spot trades and options. Although EUAs can be traded on several exchanges, the ‘over the counter’ market still accounts for most of the volume.16 The price of EUAs was €7-10 for most of 2004 and early 2005. From 16

Carbon Market Europe, September 16, reports that almost 8 million of the 9.6 million EUAs traded


March to July 2005 the price increased steadily to a peak of almost €30. Since then the price has fluctuated in the range of €20-€25.

3. United Kingdom Emissions Trading Scheme The UK ETS began operation in January 2002 and will run for five years (DEFRA, 2001).17 There are three types of participants in the scheme: direct participants, who take on absolute targets for GHG emissions; Climate Change Agreement (CCA) facilities, which have emission reduction targets usually based on energy intensity; and individual emission reduction projects, which may generate saleable GHG credits. While the direct participant and CCA components are up and running, the project component has been stalled and now appears unlikely to go ahead. The direct participant sector consists of a 32 firms that have taken on absolute targets for GHG emissions in exchange for direct subsidies from the government.18 The CCA sector can be split into two groups: a small number that have absolute targets for energy use or GHG emissions, and the much larger number that have relative targets (e.g., GWh/output). The trading rules differ between these two groups, in that trading with the ‘CCA absolute sector’ is unrestricted, while trading with the ‘CCA relative sector’ is constrained by the provisions of the ‘Gateway’. Table 2-4 illustrates the relative size of the direct participant and CCA sectors, while Table 2-5 summarizes the key features of these two parts of the scheme.

17 18

during the week were traded in the over the counter market – between the buyer and seller directly or with the aid of a broker. Part of this section is reproduced from Kim et al. (2003). Refer to Chapter 3 of Kim et al. (2003) for a more detailed description and evaluation of UK ETS. Approximately 60 installations of direct participants are also subject to the EU ETS. They have been given approval to opt-out of the EU ETS until their commitments under the UK ETS end on 31 December 2006. A proposed opt-out arrangement covering the far more numerous installations covered by a CCA agreement and the EU ETS is being reviewed with the European Commission.

22


Table 2-4. Comparison of direct participants and CCA sectors of the UK ETS CCAs

DPs

Number of firms

5500

34

Number of sites

12,000

1000

Emissions covered (MtCO2e) Emission reductions in final year from base year (MtCO2e) Average emission reduction per year(MtCO2e)

100 9.2 0.9

30 4.0 0.8

Note:

Two direct participants dropped out of the programme, so 32 remain.

reductions were to be 11.88 MtCO2e from 2002 through 2006.

Their cumulative

During 2002 and 2003 they achieved

reductions of 4.6 and 5.2 MtCO2e respectively, almost 7.5 MtCO2e more than their targets.

In 2004

six of the participants agreed to more stringent targets that will increase the cumulative reductions through 2006 to 20.78 MtCO2e. Source: (Kroger, 2003)

Table 2-5. Key elements of the direct participant and CCA components of the UK ETS

Compliance periods Type of target

Allocation of allowances

Sectors included Number of participants Basis

Direct participants

Climate Change Agreements (CCAs)

Annual targets decreasing each year from 2002 through 2006

Targets defined at two yearly intervals up to 2010. Firms allowed to choose either relative or absolute targets for either energy use or CO2 emissions. In practice, most have chosen relative energy targets. Baseline and credit trading arrangements from existing CCA targets. Allowances can be used to meet targets and can be generated when facilities exceed their targets. All sectors regulated under IPPC, but with no size threshold. Some energy intensive installations in non-IPPC sectors are also eligible. ~5500 firms and 12,000 individual sites

Absolute GHG emissions. Distributed via an ‘incentive auction’, in which participants bid for government subsidies. Six firms agreed to revised targets in 2004. Voluntary participation. Open to organisations in the public, commercial and industrial sectors. Initially 34, now 32 organisations and ~1000 individual sites. Participants adopt targets for combustion and process

Firms adopt targets for energy use or CO2 emissions. Latter applies to combustion


Links with JI/CDM Links with other countries schemes Monitoring, Reporting and Verification

Allowance tracking

Sanctions

Banking

emissions of all six Kyoto gases. These include indirect emissions from electricity consumption, estimated using a fixed conversion factor for the carbon content of purchased electricity. Interfaces to JI, CDM and IET proposed, but not possible until after 2008 and subject to approval by UK government. Interfaces to third party trading schemes proposed but subject to approval by UK government.

sources (not process) and includes indirect emissions from electricity consumption.

Monitoring and reporting in accordance with IPPC, WBCSD and other standards, with verification by an independent third party accredited by the UK Accreditation Service. Registry maintained by the UK government, intended to evolve into international registry for IET. £30/tCO2e fine for excess emissions.

Monitoring and reporting in accordance with IPPC, WBCSD and other standards, with verification by an independent third party accredited by the UK Accreditation Service.

Banking allowed up to 2007. Government reserves right to restrict banking into the commitment period.

Interfaces to JI, CDM and IET proposed, but not possible until after 2008 and subject to approval by UK government. Interfaces to third party trading schemes proposed but subject to approval by UK government.

Registry maintained by the government, intended to evolve international registry for IET.

UK into

Payment of Climate Change Levy at full rate (about £4.6/tCO2 to £9.4/tCO2, depending on fuel) for the subsequent two years. Banking allowed up to 2007. Government reserves right to restrict banking into the commitment period.

Source: DEFRA (2001).

The focus of the UK ETS is a cap-and-trade scheme for organizations that take on absolute emissions targets. The most important point to note is that this is a voluntary scheme in which a financial incentive is provided by governments to encourage organizations to take on a cap. This means that the scope of the cap-and-trade scheme is not defined at the outset, but is

24


established by industry's response to the financial incentive.19 A second point to note is that the scheme applies to all six GHGs and that the majority of emission reductions achieved through the scheme are for non-CO2 gases. A third point is that the coverage of CO2 emissions includes both direct emissions from the site and indirect emissions associated with the consumption of electricity at the site. The latter are calculated by means of a fixed emission factor for the carbon content of purchased electricity. The government held an ‘incentive auction’ in March 2002 for potential direct entry participants. Companies were invited to bid emission reductions against a defined baseline in exchange for subsidy payments totaling £215 million over five years (i.e. £30 million per year). 20 A wide range of organizations in the industrial, commercial and public sectors were eligible to participate in the auction, but not sources that were already subject to a CCA. Thirty-four companies were successful in this auction and committed to reduce emissions by a total of 4.03MtCO2e in 2006. This figure was much greater than anticipated, and represents about 6% of the total reductions required in the UK Climate Change Programme. Two of the successful companies subsequently withdrew from the scheme, leaving 32 remaining with total targets in 2006 of 3.96 MtCO2e and cumulative reductions of 11.88 MtCO2e subsequently increased to 20.78 MtCO2e. The ‘descending clock’ auction began with the announcement of a starting price of £100/tCO2. Participants then bid the quantities of emission reduction they were prepared to make at this price.21 The government then multiplied the price by the total quantity bid and found that it exceeded the total budget available. The price was then reduced and the bidding process repeated until the total quantity of emission reductions multiplied by the final price was equal to £215 million. The final price corresponded to an incentive of £17.79 per tonne of CO2e emission reduction over the lifetime of the scheme. The total emission reduction bid by each participant was divided into five increments, so that each participant’s allocation decreases by one-fifth of its total reduction target each year. The baseline for each target was typically the average annual emissions for the three-year period preceding the start of the 19 20 21

The number of participants indicates that industry considered the financial incentives to be very attractive. The incentive payments are taxable, so the payments of £215 have an after tax value of £150 million. Although the quantity bid was the reduction to be achieved during 2006, this would entail progressively larger reductions from 2002 through 2006 yielding a cumulative reduction three times the quantity bid for 2006.


scheme. The initial period of trading began in April 2002, with annual compliance deadlines until March 2007. The penalty for non-compliance is a fine of £30/CO2e, which creates a ceiling on the allowance price. Any surplus emission allowances can be banked until 2007, while the government allows participants to bank into the first Kyoto commitment period ‘up to a maximum limit of the emission reductions below their target which they have achieved themselves’. In other words, it is not possible to ‘buy to bank’. In contrast to the direct participant sector, which was designed as a cap-and-trade scheme from the outset, the CCA sector represents a set of negotiated agreements with baseline and credit trading arrangements. The Climate Change Agreements (CCAs) are negotiated agreements between energy intensive ‘facilities’ and the government and cover the period 2001 to 2013. CCAs give facilities exemption from 80% of the CCL, provided they take on binding targets for energy use or CO2 emissions. The targets are defined for two-yearly intervals up to 2010 and may be either absolute (e.g., MWh or tCO2e) or relative (e.g., MWh/output or tCO2e/output). The targets cover CO2 emissions only, and cover both direct emissions and indirect emissions from electricity consumption. The penalty for non-compliance is a return to paying the full CCL for the following two years. Eligible facilities are those in sectors which are regulated under IPPC and include many facilities which lie below the IPPC size threshold. However, oil refineries and electricity generators are excluded from the scheme. CCAs have been negotiated with 44 industrial sectors representing around 5500 companies and 12,000 individual facilities. The government initially estimated that these would reduce CO2 emissions by 9.2 MtCO2/year by 2010, corresponding to ~12% of baseline emissions (DETR, 2000). The UK ETS introduces additional trading arrangements for the CCAs, which allow facilities to generate ‘allowances’ if they perform better than their target, and to use allowances for compliance if they perform worse than their target. Allowances can only be generated for overcompliance during the one year ‘milestone period’ leading up to the biennial milestone deadline. Overcompliance in the year preceding the milestone period does not count and cannot be sold or banked. The banking or sale of allowances is only possible ex-post, once compliance with the milestone targets has been verified by third party. Allowances can be traded with other CCA facilities and also with the direct participants in the UK ETS, subject to the ‘Gateway’ being open.

26


To prevent any violation of the emissions cap for direct participants, a ‘Gateway’ was established to prevent the net sale of allowances from the CCA sector to the direct participant sector. The Gateway operates in real time and participants are able to check its status on the Registry web site. The large reductions achieved by direct participants during 2002 and 2003 resulted in net sales from participants with absolute targets to CCA participants with relative targets, so the Gateway has remained open. According to IETA and World Bank (2005), the UK market has seen limited activity in 2004, with an approximate 534,000 tCO2e exchanged. Activity in the first three months of 2005 for 2004 compliance has been very limited (about 107,000 tCO2 exchanged). Prices have oscillated between £1.68 and £3.80 per tonne of CO2e.

4. Australia 4.1

The New South Wales Greenhouse Gas Abatement Scheme

The NSW greenhouse gas abatement scheme took effect on January 1, 2003 and will continue through 2012. An annual greenhouse gas emissions cap for electricity consumed in the state is established by multiplying the population by an emissions benchmark.22 Electricity retailers, customers that obtain their electricity directly from the national market, and large users that elect to participate, are allocated a share of the cap equal to their share of total electricity consumption.23 The scheme has 23 mandatory and 8 voluntary participants. Each participant’s emissions are equal to its actual electricity consumption multiplied by the greenhouse gas emissions coefficient for NSW electricity.24 If a participant’s actual emissions exceed its allocated share of the emissions cap it must surrender abatement certificates equal to the difference. Participants can also count federal 22 23 24

The emissions benchmark declines linearly from 8.65 tCO2e per capita in 2003 to 7.27 tCO2e per capita in 2007 and then remains constant through 2012. Large users have annual electricity consumption in excess of 100 GWh with at least 50 GWh at one site or designation by the Minister of Planning. The emissions coefficient was 0.897 tCO2e/MWh in 2003. The coefficient is expected to rise to between 0.94 and 0.96 tCO2e/MWh in 2009.


renewable energy certificates (RECs) associated with electricity purchases in NSW toward compliance.25 Abatement certificates can be earned through low-emission generation of electricity, activities that reduce consumption of electricity, carbon sequestration in forests, and approved large user abatement activities. As of early 2005 approximately 93 companies had been accredited as abatement certificate providers. They had implemented over 134 approved projects that generated 12.3 million certificates; 11.1 million from generation activities, 1.0 million from demand management and 0.2 from carbon sequestration. Almost 1.2 million certificates were used for 2003 compliance and 5.0 million certificates were used for 2004 compliance. The demand is expected to rise to 20 million certificates by 2012. By early 2005 approximately 4.5 million certificates had been traded in 145 transactions, with certificates trading at prices between A$10 to $14 tCO2e. The penalty for surrendering insufficient certificates is A$10.50 tCO2e, effectively setting a price cap of A$15.26 There are no restrictions on the banking of abatement certificates. A participant may “borrow” up to 10% of its cap allocation provided that the deficit is repaid the following year.27 MacGill et al. argue that the market is dominated by a few buyers and sellers and that most of the reductions are not additional.28 In 2003 the largest supplier created 46% of the certificates and the three largest suppliers provided over 70% of the certificates, while three electricity retailers owned by the NSW government accounted for most of the purchases. They claim that over 95% of 2003 certificates came from installations that were built or committed well prior to the commencement of the scheme and that no operational changes 25

26

27 28

The Commonwealth Renewable Energy (Electricity) Act 2000 requires that an increasing portion of the electricity sold in Australia be from new (post 1997) renewable sources. Generators receive renewable energy certificates (RECs) for electricity supplied by qualified renewable sources. Electricity retailers and wholesale customers must hold RECs equal to the required share of their sales/purchases. RECs used for compliance with the NSW greenhouse gas scheme are multiplied by the emissions coefficient. The penalty is adjusted annually by the consumer price index. The penalty is an after tax expense, while the purchase of certificates/allowances is tax deductible. Australia's corporate tax rate is 30%, so the penalty effectively sets a price cap of AU$5 for certificates/allowances. In other words, the certificates surrendered can be less then the required quantity by up to 10% of the cap allocation. Borrowing is not allowed in 2007. MacGill, Iain, Robert Passey, Karel Nolles and Hugh Outhred, 2005. “The NSW Greenhouse Gas Abatement Scheme: An assessment of the scheme’s performance to date, scenarios of its possible performance to 2012, and their policy implications,” Draft CEEM discussion paper DP_050408, Center for Energy and Environmental Markets, University of New South Wales, Sydney, April 2005.

28


were required by these projects to create the great majority of these certificates. They also estimate that 70% or more of all certificates created over the scheme’s life may not represent additional abatement. The Australian Commonwealth Territory (ACT, Canberra) joined the NSW Greenhouse Gas Abatement Scheme effective January 1, 2005. Benchmark participants in NSW and the ACT will be able to surrender certificates created for eligible abatement activities in either NSW or the ACT to meet their obligations. The NSW Scheme Administrator is also the scheme administrator for the ACT. The ACT's Independent Competition and Regulatory Commission will be responsible for compliance regulations for ACT participants.

Table 2-6. Operation of the NSW Greenhouse Gas Abatement Scheme

Emissions benchmark (tCO2e per capita) Emissions cap (mtCO2e) Actual/projected “emissions” (mtCO2e) Certificates generated (mtCO2e) Certificates used for compliance (mtCO2e) Shortfalls carried forward to next year (mtCO2e) RECs counted toward compliance (mtCO2e) Banked certificates at end of year (mtCO2e)

2003 8.65 57.768 56.671 6.663 1.167 0.045 0.488a) 2.688

2004 8.31 56.110 59.498 5.594 5.038 0.142 0.762 6.052

2005 7.96 54.226 60.816

Note: a) 544,518 RECs, which were equivalent to 488,432 NGACs; and 841,194 RECs, which were equivalent to 762,122 NGACs.

4.2

National Emissions Trading Taskforce

State and Territory Governments in Australia established a taskforce to develop a national greenhouse gas emissions trading scheme. The taskforce reported on its progress in December 2004 and were directed to continue their work in March 2005. Ten principles have been agreed as the basis for further investigation and analysis: • •

A cap-and-trade design will be used for scheme design; The scheme is to be national and sector based;


•

In setting the cap, consideration is to be given to the overall national emissions abatement target, and how the abatement responsibility is allocated between sectors covered by the scheme and those outside the scheme; • The scheme will initially cover the stationary energy sector (including electricity, gas and coal); • The scheme will cover all six greenhouse gases under the Kyoto Protocol; • Permit allocation will include a mix of administratively allocated and auctioned permits, with both long and short term (annual) permits; • The penalty should encourage compliance and establish a price ceiling for permits; • Offsets will be allowed; • Mechanisms to address any adverse effects and structural adjustments must be included; and • Mechanisms for new entrants and participants who have taken early abatement action must be included. The taskforce will undertake further investigation and analysis during 2005 to gain a better understanding of the potential impacts of an emissions trading scheme on: • •

Compliance costs; Impacts on specific industries (e.g., energy intensive and trade exposed) and structural adjustment issues; • Regional impacts and associated labor market issues; • Impacts on consumer energy prices and small business; and • Macroeconomic impacts such as economic growth, employment, investment and inflation. This work will incorporate economic modeling where necessary to guide the analysis. A public discussion paper is expected to be released late in 2005.

5. Large Final Emitter and Offset Systems of Canada Steps to implement a greenhouse gas emissions trading programme for large industrial sources are now underway in Canada. In July 2005 the

30


government published a “Notice of intent to regulate greenhouse gas emissions by Large Final Emitters” under the Canadian Environmental Protection Act.29 Discussion papers on elements of the regulatory framework are expected to be released in late 2005 and early 2006. The proposed Large Final Emitter (LFE) regulations will be published following public consultations on the discussion papers. The final regulations are expected to come into force in 2007 so the programme can begin on January 1, 2008. Canada’s 2005 climate change plan reaffirmed the government’s intent to implement a trading programme for the greenhouse gas emissions of Large Final Emitters. 30 Over the previous 2.5 years work on design of the LFE programme had been undertaken by Natural Resources Canada. The decision to implement the programme using the Environmental Protection Act led to the transfer of responsibility of the programme to Environment Canada with almost completely new staff. LFEs are firms in the thermal electricity, oil and gas, and mining and manufacturing sectors that have average annual GHG emissions per facility of 8 kt CO2e or more and average annual emissions of 20kg CO2e or more per C$1000 of output. LFEs include: electricity generators that use natural gas, oil or coal; firms engaged in oil and gas production, processing, transmission and distribution; chemicals; fertilizers; pulp and paper; mining; smelting and refining; aluminum; steel; cement; lime; and glass. Other manufacturing industries, such as assembly operations, are excluded. The LFE programme will cover about 700 firms.31 They are responsible for almost half of Canada’s greenhouse gas emissions. As usual, a minority of the firms, 80 to 90, are responsible for most (85%) of the group’s total emissions. The projected average annual emission reduction by these sources for 2008-2012 is 45 MtCO2e, down from 55 MtCO2e in the 2002 climate change plan. LFEs will have mandatory emission intensity targets (tCO2e per unit of physical output). Fixed process emissions will have a 0% reduction target for 2008-2012.32 All other emissions will have a 15% intensity reduction target 29 30 31 32

Canada Gazette, Part I, July 16, 2005, pp. 2489-2502. Government of Canada, 2005. Moving Forward on Climate Change: A Plan for Honouring Our Kyoto Commitment, Government of Canada, Ottawa, April. An issue yet to be resolved is whether the participants are firms or facilities. A de minimis threshold of 20 or 50 kt CO2e per year for a firm had been proposed by Natural Resources Canada. Some emissions, such as transportation emissions, may be excluded. Offset credits could be earned for reduction of excluded emissions.


relative to a 2010 business-as-usual forecast, not to exceed a reduction of 12% of total emissions.33 Emission intensity targets for large new facilities and existing facilities undergoing major transformations or expansions would be based on Best Available Technology Economically Achievable. LFEs will be able to comply by reducing their own emissions, buying credits from other LFEs, CDM credits (CERs), JI credits (ERUs), “greened” AAUs, domestic offset credits, or Technology Investment Units.34 While LFEs will be able to use Kyoto units for compliance, they will not be able to exchange LFE credits for Kyoto units for sale internationally. LFEs may buy Technology Investment Units at a cost of C$15/tCO2e to a maximum overall contribution of 9 MtCO2e per year for compliance.35 Money from the sale of Technology Investment Units will go into a fund that will help finance research into, or the development or demonstration of, technologies or processes to reduce greenhouse gas emissions from industrial sources or to remove greenhouse gases from the atmosphere in the course of an industrial operation. Since LFEs should benefit from the technology development in the long run, they may prefer this compliance option over the purchase of credits even if the price of credits is lower. The Canadian Government has committed to implement a “price assurance mechanism” to ensure that LFEs will be able to meet their regulatory obligations at a cost of no more than C$15/tCO2e (estimated to be about US$10/tCO2e) for the period 2008–2012. Details of this mechanism are not yet available. Natural Resources Canada had proposed that a participant that wished to use this mechanism would enter into an agreement for a maximum quantity prior to the start of the year. It would pay a premium (unspecified), like an insurance premium, for the price guarantee. To receive price guarantee units, the participant would pay the government $15 per credit for the lesser of the quantity needed to achieve compliance (after using all allocated units) and the maximum quantity agreed at the start of the year. Price guarantee units would not be tradable.

33 34

35

Natural Resources Canada had proposed that the intensity targets decline by 3% per year from 106% of the 2010 target in 2008 to 94% of the 2010 target in 2012. A participant’s credit allocation will be calculated in terms of t CO2e using the intensity target and its actual output during the year. Each credit will permit the owner to emit 1 t CO2e during or after a specified year. Thus the Fund will not exceed C$675 million. The government is not expecting emission reductions due to spending by the Technology Fund during 2008-2012.

32


Credit for early action and industrial competitiveness are considered to be addressed by the emission intensity targets. No additional provisions are being considered. While not explicitly mentioned, it is expected that credit banking, but not borrowing, will be allowed. Accounting and tax treatment of credit purchases and sales have not yet been proposed. A penalty of no more than CA$200 per tonne of excess emissions is proposed. The federal Government is prepared to negotiate equivalency or administrative agreements with interested provinces and territories to implement the LFE programme in a manner that will ensure national consistency while allowing for a single regulator in any given jurisdiction. Federal, provincial and territorial governments are working to develop a single, harmonized system for mandatory reporting of greenhouse gas emissions and related information. Participants will be required to report emissions and production data for a given calendar year by June 30 of the following year, leading to the assessment of compliance by September 30, and a true-up period ending on December 31. The federal government also has launched public consultations on a proposed Offset System for greenhouse gases.36 It is designed to encourage cost-effective incremental reductions or removals (carbon storage) of greenhouse gases in activities not covered by federal greenhouse gas regulations. Projects are expected to include increased sequestration by forest and agricultural soil sinks, storage in geological reservoirs, reduction of landfill gas emissions, and emission reductions resulting from clean energy, demand-side management, and co-generation. Some reductions/removals eligible to earn offset credits will not contribute to meeting Canada’s Kyoto commitment. Emission reductions in other countries by Canadian firms engaged in cross-border trucking may be eligible. Geological storage of CO2 imported from the United States may be eligible. Forest management projects may be eligible even if Canada does not include forest management in its Kyoto accounting. 37 Emission reductions from January 1, 2006 may be eligible. So it will not be possible to exchange offset credits for Kyoto units.38 Offset credits can be sold to LFEs or the federal government’s Climate Fund. 36 37 38

Government of Canada, 2005. Offset System for Greenhouse Gases, Government of Canada, Ottawa, August. Provisions to address non-permanence also may differ from those for the Kyoto Protocol. Canada will not host Joint Implementation projects.


The Climate Fund is likely to be the larger market; it plans to buy 75 to 115 MtCO2e of domestic and international units annually while the reduction target for LFEs is 45 MtCO2e per year. The process proposed for the Offset System is similar to that of the Clean Development Mechanism (CDM). A project will need to use an approved “quantification protocol” or “quantification methodology”. 39 The protocol/methodology will specify the project boundary, baseline, leakage, and monitoring requirements. The participants must demonstrate they have clear legal ownership of the reductions/removals. The offset programme authority will validate the proposed project. The emission reductions/removals must be verified ex post by an accredited independent expert at intervals selected by the project participants. The offset programme authority issues credits based on the report by the accredited expert. All projects have a fixed registration period of eight years that can be renewed if the project is re-validated, possibly with a revised baseline. Registration periods must be contiguous.

6. United States 6.1

The Regional Greenhouse Gas Initiative

The Regional Greenhouse Gas Initiative (RGGI) involves nine states in the northeastern United States. Participating states would implement an emissions trading programme for CO2 emissions by electricity generating units. The emissions cap would be set at approximately 150 million tonnes from 2009 through 2015 and then decline by 10% between 2015 and 2020. The initial emissions cap would be apportioned among the participating states as shown in Table 2-7.

39

Protocols will be developed by government experts for specified project types based on methodologies approved by the CDM and other programs. If a suitable protocol is not available, a new methodology can be proposed.

34


Table 2-7. Initial Emission Caps by State State40 Connecticut Delaware Maine Massachusetts New Hampshire New Jersey New York Rhode Island Vermont Total

Cap (short tons) 10,957,575 7,570,787 5,492,902 25,335,204 8,645,460 23,009,554 65,576,805 2,665,239 1,348,830 150,602,356

The initial state caps are approximately equivalent to the average emissions of the highest 3 years between 2000 and 2004. Consideration was also given to electricity consumption, population, potential emissions leakage, and provision for new sources. A comprehensive review in 2015 will assess, among other things, the programme’s success in meeting its emissions reduction goals, price impacts, the numerical limit on offsets, the viability of additional reductions after 2020, and the extent to which the programme has caused increases in imports and associated emissions leakage. Decisions on the allocation of allowances to individual generating units will be left to each state, except: •

All states agree to set aside 5% of their emissions budget for the regional Strategic Carbon Fund (SCF). • All states agree to propose -- for legislative and/or regulatory approval -- that 20% of the allowances be allocated for a public benefit purpose. New source set-asides will be created at the discretion of each state. The states are served by electricity grids connected to generators outside the region. Thus, the regional CO2 constraint may lead to increased electricity imports and associated emissions leakage. The states will monitor electricity 40

On December 16 it was reported that Massachusetts and Rhode Island has decided not to participate in RGGI.


imports into the RGGI region and evaluate the extent to which increased imports may have been caused by the emissions cap.41 The Strategic Carbon Fund (SCF) will help to offset potential emissions leakage.42 The SCF will develop greenhouse gas emission reduction and carbon sequestration projects. Public benefit purposes may include the use of allowances to promote energy efficiency, to directly mitigate electricity rate impacts, promote renewable energy technologies, and/or to stimulate or reward investment in technologies that will reduce CO2 emissions from power generation in the state. The programme will have a robust offsets component: •

• •

From the start of the programme, offset credits will be issued for landfill gas, sulfurhexaflouride (SF6), afforestation, and natural gas/home heating oil/propane end-use energy efficiency projects within a RGGI state. Additional offset types, such as sustainable forest management, will be added to the programme over time. If the price of allowances reaches a set level on a sustained basis, European Union Emissions Trading Scheme allowances and Clean Development Mechanism credits will be allowed as offsets.

The use of offsets for compliance in each period will be limited to 50% of the difference between the projected business as usual emissions and the emissions cap. Specific numerical limits will be included in the Memorandum of Understanding among participating states. Offsets will also be part of the 2015 review, in order to re-evaluate their role and to determine whether the limits should be adjusted.

6.2

Massachusetts and New Hampshire

Massachusetts and New Hampshire have legislated emissions limits for old (pre-1977), fossil-fired generating units in their states. These units are targeted 41

42

Electricity imports will be monitored on an annual basis. The significance of any emissions leakage and whether additional measures to address emissions leakage should be implemented will be considered as part of the 2015 review. States may agree to additional measures prior to the 2015 review if warranted. By setting the SCF contribution at 5% of the allowances, states estimate that the emissions cap will lead to leakage of 5%. Using revenue from the sale of SCF allowances to fund emission reduction and sequestration projects will help offset the leakage.

36


because they are exempt from the provisions of the federal Clean Air Act.43 Both states set limits on the NOx, SO2, mercury and CO2 emissions of these units. The Massachusetts legislation applies to about ten generating stations. The CO2 limits take effect between 2005 and 2010.44 Each generating station must keep its CO2 emissions below its past emission levels for the three-year period 1997-99. Each station must also keep its CO2 emissions intensity below 1,800 lb/MWh. Off-site emission reductions or sequestration may be used to comply, provided they meet programme guidelines. Trading and banking are allowed. New Hampshire has set a CO2 emissions cap of 5,425,866 tonnes annually for the three generating stations affected, all of which are owned by Public Service of New Hampshire (PSNH). This cap applies from 2006 through 2010 after which a lower cap is to come into effect. PSNH can earn credits for energy efficiency, renewable energy, and conservation programmes and for reducing its emissions below a three-year moving average. It will also be able to use specified emission reductions from other jurisdictions and to bank surplus allowances and credits.

7. Japanese Voluntary Emissions Trading Scheme 7.1

Climate Change Policy

As the Kyoto Protocol entered into effect, Japan is faced with the binding goal of 6% GHG reduction from the level of 1990 emission. This reduction goal is considered to be quite a feat for an already energy efficient economy like Japan. Various policies and initiatives from the government and private sector are formulated and implemented. In line with these efforts, the Japanese Cabinet established the ‘Global Warming Prevention Headquarters’ headed by 43

44

The Clean Air Act imposed emissions regulations, including SO2 trading, on new units with the expectation that existing units would be retired gradually. But many old units are still operating and their emissions per MWh are much higher than those of newer units. The first compliance date for a facility, between 2004 and 2008, is determined by its compliance with the NOx and SO2 requirements. The CO2 emissions cap takes effect the next year and the CO2 intensity limit comes into effect the second year after the first compliance date.


Prime Minister Koizumi Junichiro and co-Vice Chiefs, Minister of the Environment and Minister of Economic Trade and Industry. Its main objectives are achieving a 6% reduction target set by the Kyoto Protocol and long-term emissions reduction on a global scale. As of 2002, Japanese GHG emission is 7.6% above the level of 1990. With existing policies and plans total GHG emission is expected to reach 6% above 1990 level. Japan plans to introduce additional domestic measures to reduce GHG emission further, to 6.5% less than the 1990 level. Among other measures, the Mandatory Greenhouse Gas Accounting/Report policy and Environmental Tax Policy are notable. The Mandatory Greenhouse Gas Accounting and Reporting system is a legally binding system in which large emitters report their GHG emissions to administrative bodies, which would then release the data to the general public. This will provide incentives for firms to reduce GHG emission by way of public pressure. But more importantly, an environmental tax is being seriously discussed in the political arena, as it is expected to be a major workhorse amongst Japanese climate change policies. The Japanese Ministry of Environment tabled a concrete Environment Tax proposal in November 2004, in which it proposed a JPY (Japanese Yen) 2,400/tC tax rate. At the same time, the Liberal Democratic Party of Japan submitted a proposal where a 3,000/tC tax rate was proposed. This tax plan is currently being heavily discussed and negotiated. Even with those and other policies, Japan’s expected reductions fall short, 5.5% more than required by the Kyoto target emission reduction. Japan intends to use a sink option to achieve an extra 3.9% reduction, while the remaining 1.6% is expected to be made up by utilizing the Kyoto Mechanism. In particular, Japan provides financial incentives to CDM/JI project developers, in the form of up-front payments for up to 50% of the total project cost. The budget for the 2005 fiscal year was 54 - 76 million US dollars. Japan also introduced a Voluntary Domestic Emissions Trading scheme, which will be further elaborated in the following section.

7.2

Japanese Voluntary Emission Trading Scheme (JVETS)

The Japanese Ministry of Environment has set up the Voluntary Domestic Emissions Trading Scheme (JVETS), which will be operational from April 2006

38


until March 2007. Participants have pledged to reduce their CO2 emissions from specific installations by 26,380 tonnes over this period. JVETS is designed to be a part of the compliance tools for the Kyoto Protocol. In particular, this voluntary mechanism seems to be a prototype scheme for the accumulation of data on effectiveness and efficiency before it assimilates into a full-fledged policy mix. The main objectives of JVETS are to gain real experience in trading, verification, and compliance assessment. JVETS was launched in May 2005, and works as follows. Private companies are invited to commit their CO2 emission reduction. Applications are on a site/facility basis, and must provide information such as new facility installation costs, base year emission (i.e. overall average for the past 3 years), and the expected amount of emissions reduction for the 2006 fiscal year. The Ministry of Environment then reviews applications and selects subsidy recipients based on the ‘cost efficiency’ criteria. If selected, companies will receive one third of the installation cost, a maximum of 200 million Yen, as a subsidy. JVETS follows a rather tight timeline. Applications were made in April 2005. The installation of new facilities, verification of baselines, and the allocation of emission allowances must be done by April 2006, the commencement of its operational period. The operational period ends March 2007, upon which verification of actual GHG emission is made. Participants may trade allowances anytime during the operational period, but an additional trading period will be given in June 2007 for those participants who could not meet the reduction goal. If a participant still could not retire allowances corresponding to the actual amount of their emissions, the subsidies provided to them must be returned. 34 out of 38 applicants have been selected to receive subsidies totaling 2.6 billion yen. The total base year emission, averaged between 2002-2004, was 1,311,241 tCO2 per year, and the pledged reduction target for 2006 was 276,380 tCO2, amounting to 21% of the total emissions from 34 facilities. As the installed facilities last many years, total emission reduction throughout the facilities’ lifetimes is estimated, or pledged rather, to be 3,750,311 tCO2. It is equivalent to a subsidy of JPY 692/tCO2.


7.3

Evaluation

JVETS could provide a good basis for future cap-and-trade schemes. As the programme’s experience in baseline setting, verification of emissions, registry management, coping with leakage and links etc. grow, the possibility of a smooth transition to the Kyoto Protocol budget period increases. Its cost effectiveness is another source of pride for this programme. The cost to the government of JPY 692/t-CO2, equivalent to about $6/t-CO2, is very low considering the international carbon price. More encouraging is the fact that it has attracted 34 participants under a voluntary participation scheme. Considering that each participant still has to pay 2/3 of the facility installation costs, voluntary participation in the absence of external threat would be hard to come by. Understanding the underlying incentive structure may yield valuable implication for a full-fledged emissions trading scheme in the future. However, JVETS is not without hurdles to overcome. The question, ‘Do we still need a pilot programme? If so, until when?’ is an important one. Japan, under the auspices of the Ministry of Environment and the Ministry of Economy, Trade, and Industry, finished the first round of a pilot phase project of domestic ETS for 2003-2004. Another pilot programme without a very specific and tangible learning objective would just be a waste of time and money. Many experts expect that a Japanese domestic ETS will not be launched by the end of 2007. All the learning from its pilot programme would be of marginal importance if a domestic ETS is not successfully linked to other international ETS such as EUETS. JVETS is just one option, and not the most popular one either. Keidanren has a voluntary achievement plan, which is, by the economic impact of the participants, the benchmark of the industry sector.45 A lack of participation in JVETS by the major emitting industries like electricity, steel, and petro-chemicals is discouraging. The total emission of 34 participants is only 0.021%of Japan’s 2004 total emissions. Simply speaking, JVETS is too small to make even a dent. Furthermore, JVETS has a serious design flaw in that it is a facility-based programme, not a firm-based one, and so it is vulnerable to the problem of 45

Among these 34 companies, only two, Nippon Electric Gas Co. and Mitsubishi Gas Chemical Co., are the members of Keidanren.

40


leakage. As a firm has multiple facilities, reducing emissions in one facility that is a participant in JVETS while increasing emissions in its other facilities may nullify the claimed achievements of JVETS. Therefore faith and social pressure would be the real driving forces in this case.46 Finally, JVETS’ assertions of its cost effectiveness need further scrutiny. Its figures are calculated based on the assumption of a 15 years facility lifespan. If only a portion of Kyoto Protocol budget period is accounted for, government cost per t-CO2 increases to JPY 1,570 per tonne. One thing to note is that the overall cost of reduction is three times that of government subsidies, since participants pay 2/3 of the cost of reduction. All in all, whether JVETS is indeed a cost efficient option to reduce GHG emission has yet to be justified.

46

These factors may be strong enough to work, considering Japanese social atmosphere.

Chapter 3. Evaluation and Policy Implications 43

Chapter 3. Evaluation and Policy Implications

1. Initial Allocation of Allowances The distribution of allowances is one of the most difficult issues for the development of a cap-and-trade programme. 47 Cap-and-trade programmes create a valuable asset for those who own or control the emission authorizations. If emission sources receive allowances free of charge, they attain the gains from these valuable assets. Under an auction, the regulatory authority attains the value of these assets. Different allocation formulas create winners and losers among the sources participating in the programme. Harrison and Radov (2002) distinguish three basic alternatives for the initial allocation of allowances: auction, grandfathering and updating. Auctions involve the government (or regulatory authority) auctioning the allowances initially.48 Under grandfathering, allocations are provided to sources based upon historic information, such as average emission levels in the 1999-2001 period. Updating allocates allowances to sources based upon information that is updated over time. For example, allocations in 2007 might be based upon activity in 2005, allocations in 2008 based upon 2006 activity, and so on. Within the second and third alternatives, there are many additional choices. The allocations can be based on input (e.g., kilojoules of fuel input); output (e.g., kilowatt-hours of electricity generated); or emissions (e.g., tonnes of SO2 emissions). There are also choices regarding the years to use for the allocations, such as the average of recent years or the maximum value within recent years. 47 48

Baselines determine the allocations for participants in a baseline and credit program and are equally difficult to establish. The United Kingdom developed a different kind of auction, called an ‘incentive auction’, for initial allocation in its greenhouse gas emissions trading scheme, which has been running since 2002. It distributes the incentive money, secured by the government, to participants according to their bids for compensation for their reduction commitments. The financial transfer is made from the regulator to the regulated sources under the incentive auction approach, compared with financial transfers occurring in reverse under the conventional auctions for emissions trading. (See DEFRA (2001) or Section 3 of Chapter II of this report for details)

44


Table 3-1 summarizes the mechanisms used to allocate allowances initially under major existing cap-and-trade programmes. Most of the programmes use grandfathering approaches, although some of the recent NOx programmes use updating approaches. There is considerable diversity in the metrics used for allocation, including input, output and emissions. The years used in the grandfathering systems vary considerably, from a single year, an average of multiple years, to the maximum value over a multi-year period. Many of the existing programmes include additional allowances to particular sources. Additional credits are sometimes granted for an “early action” (i.e., emission reductions before the cap-and-trade programme comes into force, but after base allocations have been set), for energy efficiency projects, or for new renewable facilities. Harrison and Radov (2002) concluded that auctions and grandfathering provide the best incentives to minimize compliance costs. 49 Choosing emissions, input, or production as the metrics would not affect the efficiency of grandfathering. Updating is less efficient than either auctioning or grandfathering, since the costs of meeting the cap would be greater because updating both increases administrative costs and skews the market away from some potential low-cost emissions-reduction measures, and therefore could distort product market prices.50 From the distributional viewpoint, the three basic alternatives have very different effects. Auctioning is likely to impose a cost on participating sectors, but it tends to be relatively advantageous for consumers and taxpayers, assuming the revenues are recycled in a way that reduces other forms of taxation. Grandfathering favours sectors, but is relatively unfavorable to the sectors’ consumers and provides no taxpayer gains. Updating is less attractive to controlled sectors than grandfathering because it leads to greater compliance costs and lower price increases. The sector’s consumers could benefit, however, due to lower price increases.

49

50

Harrison and Radov (2002) consider various criteria for evaluating alternative allocation approaches. They apply allowance or emissions market efficiency, product market distortions and tax distortions to efficiency considerations. With regard to distributional considerations, they consider controlled sector burdens, and burdens and benefits to major segments of the economy, including producers, consumers, and taxpayers. Updating has an effect similar to that of a production subsidy. The allocation for additional input or output encourages higher production and hence emissions. This means that the cost of achieving a given emissions target is more costly than with an auction or grandfathering. The scale of the inefficiency depends on the formula used. In an analysis of a potential emissions trading in Alberta, Canada, Haites (2003) also found that an output-based updating allocation provides an incentive for production.


Table 3-1. Allocations Under Existing Cap-and-Trade Programmes Programme

A

Method G U

U.S. ODS Phase-out

V

U.S. SO2

V

California RECLAIM (SO2 and NOx) U.S. OTC NOx

Allocation Year

V

1 year

V

U.S. SIP Call NOx Denmark CO2 V

A=Auction,

V

3-year average

V

V

Other States OTC NOx

Notes.

Metric(s) P E

V

V

Massachusett s OTC NOx

UK CO2

I

V

V

V

V

V

V

V

V

Existing emitters in covered sectors. Existing emitters in covered sectors. Set-aside for efficiency & renewables Existing emitters in covered sectors. Additional credit allocations for early action.

V

Max out of 4 years

V

1 year

States covered under OTC.

2-year max out of 3, 6 years ago

Existing emitters in covered sectors. Set-aside for efficiency & renewables

Vary

Various.

V

2-year max out of 5

V

V

5-year average

V

V

3-year average

G=Grandfather,

Recipients

U=Update;

Existing emitters in covered sectors. Set-aside for early action. Existing emitters in covered sectors. Set-aside for non-participating sources. Participating firms.

I=Input-based,

P=Production-based,

E=Emissions-based. Authors’ notes.

U.S. SO2 programme distributes all the allowances free. 2.8% of the allowances

are withheld and sold at auction.

The money from the sale is distributed to participants

in proportion to the allowances withheld and sold. allowances owned by the regulatory authority.

Thus it is not an auction of

The purpose of the auction is to ensure

that new entrants have access to allowances; to ensure liquidity in the market. UK CO2 allowances are distributed by incentive auction. (See Section 3 of Chapter 2 for more details) Source. Harrison and Radov (2002)


The national allocation plans of the EU ETS vary by country but most of them employ free allocation based on grandfathering.51 According to Gilbert et al. (2004), with some exceptions, the caps imposed on EU ETS participants are less strict than would be required if these sectors were to make an equal contribution to meeting Kyoto as other sectors do, or if no use of the Kyoto Mechanisms was envisaged. In many cases, the caps imposed by Member States are close to the expected Business-As-Usual emissions. The Special Committee on a Future Framework for Addressing Climate Change (2004) evaluates that seven out of ten countries for which data can be obtained allocate larger emission quotas than their recent emission levels. The Committee also argues that because these countries could not conduct strict allocation of quotas due to concerns over industrial competitiveness and economic growth, and because they must also respond to increased emissions in their residential and transport sectors, they are embarking on efforts to gain emission reduction credits outside their region through CDM and JI. Up to 5% of allowances in EU ETS Phase I may be auctioned, and up to 10% may be auctioned in Phase 2. This amount includes any allowances auctioned to new entrants, and allowances set aside in a new entrants’ reserve, but not used, and then auctioned at the end of the trading period. Most Member States do not plan to auction any percentage of their allocation. Exceptions include: (1) Denmark, which plans an auction of 5% at the start of the programme (the auction pool was obtained by reducing every installation’s allocation by a proportional amount); (2) Ireland, which plans a small auction of 0.75%/year to raise revenues to administer its programme; and (3) the UK, which chose to hold back 7.7% of allowances for new entrants, and to auction any unallocated new entrants’ allowances to existing players up to the 5% overall EU limit. (EPRI, 2004)

51

The Directive specifies that at least 95% of the allowances must be distributed free to participants (90% in Phase 2) and that the allocation can not be updated during the period.

48


Source. Gilbert et al. (2004)

Figure3-1. Evaluation of EU ETS Phase I allocation plans

The UK’s experience with its incentive auction raises various potential problems.52 A major difficulty with the voluntary scheme is that it attracts companies which anticipate reducing emissions, but not those which anticipate increasing emissions. Survey results suggest that this is exactly what happened in the incentive auction, with 81% of participants reporting that their emissions were falling and only 6% reporting that their emissions were rising (Kroger, 2003). This has led to the criticism that the UK government has rewarded companies for emission reductions that they were planning to make anyway, as well as creating a one-sided allowance market that is dominated by sellers (ENDS, 2002a). However, the second problem is partially mitigated by the existence of potential buyers within the CCA sector. The bidding strategies in the auction were insensitive to price and rarely based upon estimates of marginal abatement costs (Kroger, 2003). The criticism that the auction price was significantly higher than actual abatement costs for 52

The criticism of the UK’s incentive auction below is extracted from Sorrell (2003).


most participants appears to be borne out by early experience with the allowance market and large emission reductions achieved during the initial years of the programme. Prices peaked at £12.50/tCO2e in September-October 2002, before dropping sharply to around £5.00/tCO2e and then declining further. Since the first compliance deadlines (February 2003 for CCA participants and March for direct participants), there has been very little market activity and prices have fallen to less than £2.50/tCO2e. By the end of 2002, 23 of the 32 direct participants had reduced their emissions by as much or more than their targets. For 2002 the emission reductions were 4.64 MtCO2e compared to the target of 0.79 MtCO2e and for 2003 the emission reductions were 5.18 MtCO2e compared to the target of 1.58 MtCO2e - an excess of 7.45 MtCO2e or 314%. The early stages of the direct participant scheme have been plagued by disputes over the ‘additionality’ of the emission reductions achieved. This has been the focus of a series of exchanges between the government and a prominent environmental journal (The ENDS Report), and was the subject of independent investigation by the National Audit Office (NAO). The greatest problems lie in the treatment of non-CO2 GHG emissions at the three large chemicals plants (Ineos Fluor, DuPont, Rhodia), since these are already subject to environmental regulations under the Integrated Pollution Prevention & Control (IPPC) Directive. For regulated sources, the government required that the emissions baseline should be based upon the emissions limit rather than historic emissions, so that only emission reductions that were additional to regulatory requirements would be subsidised. For the Ineos Fluor site, the government set the baseline at the site limit for annual VOC emissions according to that established by the Environment Agency. But this neglected the fact that the HFC-23 emissions regulated by the UK ETS were only one component of the overall site VOC emissions. In addition, the VOC limit included significant ‘headroom’, which meant it was unlikely to be reached during normal operation (ENDS 2002b). The net result was that the emissions baseline of 148 tonnes of HFC-23 was substantially above the actual emissions in 2000 of around 45 tonnes. This gave Ineos Fluor a surplus of around 100 tonnes, which translates into a massive 1.2 MtCO2e. This is 50% above the company’s final (2006) target of 0.8 MtCO2e and creates the possibility that ~3.6 MtCO2e of emission allowances could be banked from this one site during the course of the scheme (i.e. almost as much as the total emission reductions required by 2006). However, Ineos Fluor argues that emissions in 2000 were

50


unusually low due to plant shutdown and that the UK ETS targets go beyond regulatory requirements. The Ineos Fluor dispute is mirrored at several of the other direct participant sites (KOKO). For example, DuPont’s emissions of N2O in 2002 were only 43% of its baseline, creating an allowance surplus of 1.3 MtCO2e. This is worth £3.5 million at £2.50/tCO2e, which is on top of the £26.7 million DuPont received in incentive payments. Similarly, British Sugar is expecting to achieve compliance by closing several sites and shifting production to other, more efficient sites - a move which had already been announced prior to the start of the UK ETS. Hence, while adverse selection may be anticipated within a voluntary scheme, the problem appears to have been compounded by the difficulties in establishing baselines at several of the most important sites, coupled with the ‘amplifier’ effect of high global warming potentials for non-CO2 gases. The resulting disputes have undermined the credibility of the UK ETS and may have tarred the image of emissions trading more broadly. As discussed earlier, six direct entry participants - Ineos Fluor, Rhodia Organique Fine, INVISTA Textiles, BP, British Airways and Lafarge Cement – agreed at the end of 2004 to increase their collective emission reductions by a total of 8.9 MtCO2e over six years. In spite of such potential pitfalls, incentive auctions have several compelling advantages. First, they provide emission sources with voluntary participation incentives. Second, the magnitude of total reduction costs can be effectively capped by the amount of incentive funds. These properties are very useful for any policy instrument to induce early action to reduce emissions in developing countries. The effective cap on reduction cost seems to be quite important, particularly in the face of asymmetric information or uncertainty. We can attain valuable insight through comparison with other policy instruments such as emission taxes and simple cap-and-trade system in particular. Figure 3-2 illustrates equilibrium outcomes under asymmetric information on emission reduction costs for three policy instruments: emission taxes, cap-and-trade and incentive auction. Let’s assume that a regulator evaluates (aggregate) marginal reduction cost of emission sources as CM. In case of emission taxes, the regulator may set the tax rate at PM and if its conjecture on marginal reduction cost is right, the resulting equilibrium quantity of emission will be QM. If the true marginal


reduction cost turns out to be higher (CHigh) or lower (CLow) than expected, the equilibrium outcome (emission reduction quantity) will be QHigh or QLow. Such a wide difference would incur great uncertainty of the reduction cost, as well as the reduction amount, on emission sources and so generate huge risk to the industry. In the case of cap-and-trade policy, on the contrary, the regulator will allocate QM of emission allowances among emission sources based on its expectation of CM for marginal reduction cost. If the true marginal reduction cost turns out to be higher (CHigh) or lower (CLow) than expected, the equilibrium outcome (price of emission allowances) will be QHigh or QLow. This will also result in a great uncertainty of reduction cost, together with market price of emissions, on emission sources. Under the incentive auction, the regulator, with the expectation of CM on marginal reduction cost, will allocate incentive money of PM×QM among emission sources through the auction mechanism and equilibrium price and reduction quantity are expected to be PM and QM. In the case of higher- or lower-than-expected marginal costs, i.e., CHigh or CLow, the equilibrium price and reduction quantity will be PH and QH or PL and QL. The variance of equilibrium outcomes is much smaller than in the case of emission taxes or the cap-and-trade system. In the simple case of linear marginal cost, the total reduction cost (measured by integration of marginal cost function up to equilibrium reduction quantity) does not change at all. Such stability of the reduction cost seems to be a quite useful property, particularly when the regulator tries to induce maximum reduction efforts up to a certain amount of cost burden. PQ=W

CHigh CM

PHigh PH

O

CLow

A

PM PL PLow QHigh QH

QM

QL

QLow

Figure 3-2. Equilibrium Outcome of Incentive Auction under Cost Uncertainty

52


Maximizing reductions under a budget constraint could be seen as a reasonable policy objective of the regulator in the climate change context particularly for developing countries. Developing country governments do not have an external emission constraint and global climate change does not seem to be a major concern for domestic environmental policy. A developing country government may want to facilitate early action by private industry for reasons like capacity building and preparing for the future international regulation by way of ‘learning by doing’. In this case, the government does not want to impose high uncertainty or a great cost burden on the industry, particularly under uncertainty and asymmetric information. Under the incentive auction, successful bidders can achieve much greater incentive payments compared to their reduction costs. Assuming competitive behavior by bidders, participants are paid PM*QM in the above illustration while their total reduction cost is only half of this amount. Strategic bidding by participants or strong convexity of reduction cost function makes the net profit of successful bidders even greater.53 Conservative bidding, partially due to lack of experience, could also contribute to the benefit of participants, as is the case of the UK.54

2. Linkage Linkage issues include linkage between independent greenhouse gas emissions trading schemes, linkage with emissions trading for other pollutants such as SO2 and NOx, and linkage with tradable renewable energy certificates. EU ETS explicitly allows direct links with non-EU programmes and Norway is hoping to link its emissions trading scheme with EU ETS from

53 54

Refer to KEI(2001) for rigorous analysis of incentive auctions in a game-theoretic formulation. In the incentive auction in the UK, too few participants bid too small reduction amounts and so achieved too high rent from the auction through a very high compensation rate. This resulted in a sharp decrease of the allowance price even with an increase in market demand facilitated by climate change agreements.


2005.55 Linking trading programmes reduces the total compliance cost. Programmes can be linked directly by mutual recognition of allowances and/or indirectly by conversion to/from Kyoto units. Direct links may raise some potential issues: Linking programmes with different allocation methods can increase or decrease competitiveness distortions and linking programmes with different points of imposition, e.g., electricity emissions, can lead to double/non coverage. Linking also could make the price exceed the penalty or safety valve price of one programme, could lead to the circumvention of trading restrictions, e.g., UK gateway, and different banking rules could cause large flow into the more liberal programme. Non-Kyoto programmes could unilaterally allow the use of Kyoto units for compliance. Kyoto units would be used if their price was lower than the marginal cost of meeting the limit. Non-Kyoto units could not be used for Kyoto compliance so links are likely to be unilateral. SOx and NOx trading schemes are operating for sources in RECLAIM, Ontario, Acid Rain SO2 and NOx SIP Call. Programmes, except RECLAIM, are being extended for more sources: Ontario is extending its NOx and SOx programme to more sources and all of the sources are likely to be part of Canada’s Large Final Emitter (LFE) programme for greenhouse gases. The CAIR initiative by the EPA proposes a significant reduction of the cap for the Acid Rain SO2 participants as well as extension of geographic coverage of the NOx SIP Call programme and reduction of the NOx cap. Some of those sources would also be part of a mercury trading programme. CO2 trading programmes are being proposed by the northeastern states (RGGI) and the west coast (California, Oregon and Washington) states. Alberta has found multi-pollutant trading with NOx, SOx and GHG to be feasible for industrial sources. In Europe, NOx trading is being implemented in the Netherlands and SOx and NOx trading is being considered in the UK for sources that are already subject to CO2 trading. Increasingly, firms are likely to be faced with SOx, NOx and GHG trading, not just GHG trading. 55

The European Commission has decided that as a member of the European Economic Area, Norway and the other EEA members (Iceland and Liechtenstein) must link by adopting the EU Directives rather than by negotiating trading program links individually. As a result, these countries are unlikely to be linked to the EU ETS until 2008. Switzerland is also discussing a link with the EU ETS effective 1 January 2008. Assuming Bulgaria and Romania become members of the EU in 2007, they will need to establish trading programs within the EU ETS at that time.

54


Multi-pollutant trading is more efficient: Actions to reduce one pollutant can increase or decrease emissions of others and multi-pollutant trading addresses all emissions. Incremental regulatory costs are low since SOx, NOx and GHG can be measured by the same CEM: Extra enforcement costs are negligible. It provides proper costing of emission reduction measures since actions to reduce other pollutants earn revenue and those that increase others incur costs. It also provides more flexibility in the choice and timing of reduction efforts. Affected sources can benefit from more flexibility and lower costs to comply with air pollution regulations under multi-pollutant trading. Evaluating compliance strategies, however, will be more complex. Allowance prices for all pollutants will need to be forecast for 10 to 20 years to compare the costs of reduction options. Modeling suggests GHG reductions tend to lower SOx and, less so, NOx emissions, but SOx and NOx reductions have limited impact on GHG emissions. Planning compliance strategies to achieve potential cost savings may be complicated for many firms. Multi-pollutant trading may involve multiple regulators and increase complexity of compliance decisions.

3. Early Action, Banking and Penalty Various mechanisms for early action credits have been proposed and implemented to reward environmental leaders that reduce emissions before a trading programme starts. Implementation of credit for early action is very difficult in practice: the date of early action is arbitrary; it may reward laggards rather than leaders; and early action may make compliance easier so no reward may be needed. Several efforts to develop practical approaches to credit for early action were unsuccessful, including those of the Pew Center, a Canadian Working Group on Credit for Early Action, and the revision of the 1605(b) rules by US DOE. Canada adopted a “baseline protection” approach under which sources can implement emission reductions and register what emissions would be without these actions. It is voluntary, must include deliberate actions not required for other reasons and is subject to independent verification. The verified emission


baselines will be used for allowance allocation if appropriate. Since the Large Final Emitter (LFE) emissions trading programme currently under development will allocate allowances based on emission intensity and actual output, early action will not affect the allocation and will make compliance easier, so baseline protection will not be used.56 Various American registries record GHG reductions and might be used to support claims to credit for early action. The NOx SIP Call programme allowed states to give limited recognition to early reductions. Experience with credit for early action reveals great difficulty with implementation in practice. Banking improves efficiency through greater price stability, more liquidity and trading, lower transaction costs, more efficient adjustments to changes in the emissions cap, and incentives to develop and implement cost-effective technology. From the perspective of regulated sources, banking is a useful tool to allow hedging against uncertain future price or policy changes and to smooth abatement costs over time. From the environmental perspective, banking could result in high emissions during a future period if a large quantity of banked allowances is used. If the emissions cap is lower than the BAU emissions, the environmental impact of banking is neutral for stock pollutants and needs specific analysis for flow pollutants.57 A wide range of banking provisions has been applied in cap-and-trade programmes. The international greenhouse gas emissions trading under the Kyoto Protocol and the U.S. National SO2 Trading Programme allow unrestricted one-for-one banking, while the RECLAIM programme in California prohibits banking. The regional NOx trading programmes in the Northeastern United States utilize a restricted banking provision, called ‘progressive flow control’, to limit the use of banked allowances in a particular season. The banking provisions tend to be stricter for local programmes of narrower regional boundaries, in which temporal hot spots might be a more serious issue. 56 The baseline protection and/or compensation for early actions can be dealt with effectively under allocations through auctions or (well-designed) intensity-based updating since these methodologies automatically compensate less-emitting facilities. 57 A stock pollutant is one for which the environmental impact depends on the amount of the pollutant emitted over a relatively long period of time -- such as greenhouse gases. Hence, changing the timing of emissions due to banking does not have a significant environmental impact. A flow pollutant is one for which the environmental impact depends on current emissions, such as ozone formation due to NOx or VOC emissions. Then the environmental impact depends on the conditions at the time the emissions occur. Changing the timing of emissions banking could increase or reduce the adverse environmental impacts. If the emissions cap is greater than the BAU emissions, banking defers environmental benefits.

56


Many trading programmes experienced accumulation of relatively large bank of allowances early: Danish CO2, UK GHG, New South Wales GHG, Houston NOx, Ontario NOx, OTC NOx Budget, Illinois VOC and Acid Rain SO2. Restriction of banking encourages precise compliance which increases the rate of non-compliance. Excess emissions with non-compliance are small, however, and so total emissions may be lower with restricted banking. It is a challenge to design a banking provision that gets economic and environmental benefits without accumulating a large bank over the early years of the programme. Stringent penalties for noncompliance are an integral feature of a well-functioning cap-and-trade programme. These should be applied automatically in cases where a source does not have sufficient allowances to cover its emissions during the compliance period. In cases where there is noncompliance with the requirements of the cap-and-trade programme, (e.g., measuring emissions, reporting, and other requirements), the penalties should be based on the nature and severity of the violation. The penalties should be sufficiently high to provide the appropriate incentives for compliance and can take the form of allowance, financial, and/or criminal penalties. (EPA, 2003) Excess emission offsets and financial penalties are often considered as options for non-compliance penalties. 58 Under the U.S. SO2 Acid Rain Programme, the penalty consists of a one-to-one allowance restoration and a financial penalty of US $2,000 ($1,990), adjusted annually for inflation, for each tonne of excess emissions.59 In contrast, the penalty for non-compliance in the OTC (Ozone Transport Commission) Regional NOx Trading Programme is an allowance penalty at a ratio of three-to-one. Although individual states within the OTC have the option of imposing financial penalties, they tend not to be high. The EU ETS imposes both a financial penalty and an excess emission offset. In Phase 1, installations that do not surrender sufficient allowances to cover their emissions for the previous year by April 30th must pay an excess emissions penalty of €40 for each tonne of CO2 equivalent of excess emissions.60 They must also surrender extra allowances in the following year to compensate for their excess emissions. Countries must also publish the 58

59 60

The regulating authority might also impose criminal penalties on individuals who intentionally violate any requirements. Criminal penalties provide direct incentives for the legally responsible individuals at the affected sources to behave responsibly. In 2004 the penalty was $2,963 per tonne. The penalty increases to 100 Euros in Phase 2 of the program.


names of operators that fail to surrender sufficient allowances for compliance (the so-called “naming and shaming” provision). These penalty provisions seem to be strong enough to prevent any intentional non-compliance behavior. Concerning the Kyoto mechanisms, Article 18 of the Kyoto Protocol (KP) requires that the question of how to deal with non-compliance be addressed by a future meeting of the Conference of Parties (COP) to the KP. In 2001, the COP adopted decision 24/CP.7 which states that Parties whose emissions exceed their possession of eligible allowances (i.e. AAUs, ERUs, CERs, and RMUs) must make up the shortfall in a second commitment period and also play an interest penalty of 30%. Countries that are in non-compliance will also be suspended from using the Kyoto Mechanisms to sell additional allowances. However, at COP-7, Parties agreed that the decision on the legally binding nature of the consequences of non-compliance would be left to the first meeting of the Parties following the Kyoto Protocol’s entry into force, and that a formal amendment to the Protocol would need to be adopted. (EPRI, 2004)

4. Treatment of Closures and New Entrants In case of free allocations such grandfathering or updating 61 , the policymakers must decide how new entrants into the programme will obtain the allowances needed to operate. In some systems with updating allocations, new emission sources may receive some allowances. In the case of permanent allocations, new units may obtain needed allowances from the market. In a permanent allocation system, facilities that are shutdown may continue to receive allowances indefinitely. These allowances may then be used by the owners of the shutdown facility to cover emissions at new or other existing facilities that they own, or they can sell the allowances in the market. This system could work well when there are many facility and allowance owners and no monopoly exists on current allowance holdings. Alternatively, an allocation set-aside could be created for new entrants. The set-aside could hold 61

In the cases of auctions or direct sales, the treatment of closures and new entrants is not an issue since all existing and new installations face the same conditions (with the same prices) when they acquire allowances. It is one of the important advantages of auctions that they can avoid the complex policy design issue on the treatment of closures and new entrants.

58


a specific percentage of the overall cap to cover growth in new sources. Some analysts have noted that both economic theory and empirical experience suggest that there is not a competitive barrier to new entrants that do not receive no-cost allowance allocations in cap-and-trade programmes. These analysts argue that emission sources that receive no-cost allowances allocations have the same marginal ”opportunity cost” for every tonne emitted as the marginal cost paid by the new entrant. In support of this argument, there is no evidence of entry problems for new electric power plants under the U.S. SO2 programme, which requires new power plants to purchase allowances from the market. There has been significant entry by new units, even coal-fired units that do not receive a no-cost allowance allocation. In spite of many efficiency advantages, the permanent allocation to existing facilities, even after they have been shutdown, may raise some ethical or efficiency problems. Markus et al (2005) indicates that there are arguments for withdrawing allocation to installations that no longer operate. Allocating a stream of allowances in perpetuity based on a historic measure may defy intuition about fairness and common sense. Permanent allocation is a difficult argument to make in the face of a question such as: “Why give allowances to somebody who doesn’t need them?” This is an especially potent argument if it appears an installation would have shut down “anyway” in the absence of the programme, and the allowances are thereby deemed “anyway credits.” At the international level, similar criticisms have plagued the so-called “hot air credits” referring to emission budgets under the Kyoto Protocol for economies that have contracted since 1990. Furthermore, if allocation is removed, authorities have the control of those allowances and can either withhold them or allocate them to other installations. Should allocation not be removed but remain unchanged indefinitely, it is possible that at some point all allowances are allocated to non-operating installations. This is not necessarily detrimental to the efficiency of the trading scheme, but it means the possibilities for authorities to use allocation to drive changes in behavior, to compensate for losses, or to give rewards to desirable behavior are lost. EU ETS deserves a close examination in this regard. Three options are applied in the EU ETS.62 By far the most common is that allocation is lost if an installation is closed. However, in a number of Member States the owner of a 62

The description of EU ETS rules on treatment of closures and new entrants and the following arguments on their problems and potential solutions are extracted from Ahman et al (2005) and are reorganized with some complementary statements. See Ahman et al (2005) for more detailed explanations.


closed installation may transfer the allowances to a new installation instead of losing them altogether. A third option is to leave the allocation unaffected, but this has only limited application. In Germany an installation that is closed will receive no allowances the following year. Closure is defined as when an installation emits less than 10% of its average annual baseline emissions. Further, if an installation emits less than 60% of its average annual emissions, the quantity of allowances will be reduced by the same proportion as the reduction in utilization of capacity compared to the reference period. Thus an installation has an incentive to keep operating and to emit a certain volume of CO2 compared to the reference period. If applied strictly, this punishes both adjustments in production and mitigation measures such as switching from coal to biomass. In Germany, any allowances recalled or not issued will be placed in the new entrant reserve. If the operator of the decommissioned installation commissions a new installation in Germany within three months, producing comparable products, the allocated annual allowances of the old installation can be transferred to the new installation. The three-month deadline may be extended up to two years under special circumstances. Similar transfer rules exist in Italy, Austria, and Poland. In contrast, in Finland and Spain the transfer of allowances is not allowed. If an installation is closed, it will lose is greenhouse gas emissions permit and consequently lose subsequent allocations. Sweden and the Netherlands are the only Member States that apply the policy of letting operators keep the allocation in the case of closure. However, emission allowances are only allocated for one phase of the trading programme at a time (Germany has introduced an exception to this, see below). That is, the operator of a closed installation may find him or herself without any allocation in the next phase of the trading programme, should the regulators decide to update the allocation scheme in this way. In other words an operator keeps the allowances allocated for 2005-2007 even if the installation closes during this period, but may not be allocated allowances for 2008-2012. Hence, in reality the difference between the policies of Sweden and the Netherlands and other Member States’ may be small. Providing the correct incentives for firm behavior is the main reason why the allocation is not changed if the installation reduces economic activity or


behavior? Under competitive conditions a one-time allocation to existing sources, even an allocation of an annual stream of allowances into the future, should not affect the variable costs or going forward cost of an installation. As long as the allocation is not affected by the decision to continue operation, there is symmetry in consideration of going forward costs between existing and new sources. This symmetry preserves the desirable efficiency properties of a market-based emission trading system. Such efficiency property, however, is not guaranteed if existing installations lose allowances in the case of their closure and new sources buy allowances. The relative ranking between new and existing installations is unaffected only if the value of withdrawals from installations that close and awards to new installations are equivalent. There needs to be a strong condition requiring that the adjustments for retirement and investment decisions have the same value per unit output of production (e.g., MWh of electricity) in order not to undermine the efficiency of the ETS. Nonetheless it appears that an allocation to new sources remedies to a partial extent the imbalance between new and existing sources, although it can also impose an imbalance among the new installations. One possible approach to solve the symmetry problem between new and existing installations would be to withdraw and award allocation based on common, fuel-neutral, benchmarks. The equalization of award allocation based on a common, fuel-neutral, benchmark, however, is not an easy task in the real world, as in the EU ETS. The treatment of new entrants is one of the areas where policies among the Member States differ the most. Following is a discussion of some of the key differences for allocating to new entrants. The EU Commission only asks Member States to describe how new entrants can gain access to emission allowances. There are no rules on whether or not new entrants should be allocated free allowances. Still, all Member States guarantee a certain volume of allowances will be available to new entrants at no cost, by creating a set-aside of allowances reserved specifically for new entrants. Allowances from these reserves are usually provided on a first-come, first-served basis. The most common allocation methodology is to base allocation on general emission rates, specified for a sector or a product type, and forecast activity.

62


However, benchmarks differ significantly across Member States, even for identical products such as heat or power. When sectorwide benchmarks cannot be defined, Member States often refer to Best Available Technology (BAT) as the benchmark to be used. 64 The emission factors can be specific to an installation, or common for an entire sector. The latter is mainly used in the energy sectors, but for instance, Italy also applies sectorwide benchmarks in the mineral and ceramic industries.65 Allocations to new sources that are benchmarked on fuel-specific bases would change the investment choices among new technologies. For example, if the allocation to new entrants is based on expected future emissions expressed as fuel specific benchmarks, a natural gas plant would receive more allowances than a wind plant because the latter’s expected emission is much lower than the former. Therefore a wind plant may face a large, unfair disadvantage in investment choice compared to a natural gas plant. Ahman et al (2005) suggests a delayed updating approach, called ‘the ten-year rule,’ for the treatment of closures and new entrants under EU ETS: Imagine a Member State that has chosen an emission-based allocation with the average of three reference years from 2000-2002. Until 2011, existing installations would receive allocations based on the average of 2000-2002, but in 2012 the allocation would be based on the average of 2001-2003, and so forth. If an installation reduced production or closed, it would continue to receive allowances for ten years. New entrants would first be allocated based on projected output, but after ten years the allocation would be updated. For instance, an installation starting in operation in 2005 would receive allocation based on forecasts until 2014. From 2015 onwards allocation would be based 64

65

The definition of BAT also varies across Member States. Some Member States refer to existing official EU studies (for instance the BAT reference documents or Joint Research Center, 2005). Others refer to national legislation or to the IPPC directive (European Union, 1996), which allow BAT to be defined on a case-by-case basis. In Sweden, for example, BAT is to be defined “in accordance to environmental law,” on a case-by-case basis. For energy installations, only combined heat and power plants (CHP) are eligible for allocation from the new entrant reserve. A benchmark based on a fuel mix containing significant shares of renewables is used together with forecasts of generation to calculate the allocation. In contrast, Poland does not specify how BAT will be established. Once benchmarks are selected, they are multiplied by a level of activity (e.g., output) to arrive at an allocation for sources. The most common method for estimating activity levels for new entrants is to use a forecast of future production. There are significant differences among Member States in how the forecasts are estimated and production calculated. This construction creates a range of potential problems. Basing allocation on forecasts provides an incentive for firms to exaggerate forecasts of future production. Since ex post adjustments are not allowed in the EU ETS, the only possibility for regulators to police incorrect forecasts is to update the allocation between trading periods. However, this has the potential to distort operational decisions made by firms.


on actual activity ten years previous. They argue that the ten-year rule would provide an automatic remedy to the conundrum of how to treat existing sources that reduce economic activity or close.66 If an existing installation is shutdown, it would continue to receive allowances for ten years, thereby diminishing any perverse incentives to continue operation. However, eventually the group of installations receiving allowances would slowly shift, as sources that shutdown would eventually stop receiving allowances. Under the ten-year rule the treatment of new sources would have parallel incentives. Initially, new sources would receive allowances from a reserve according to emission rate benchmarks that might be standardized across industry sectors in Europe. New installations would begin to update based on a rolling base period similar to that of existing sources. Ahman et al (2005) also acknowledges the advantages of auctions instead of free allocations and suggests a gradual transition from grandfathering to auction. For example, after ten years of free allocations, there might begin a transition period with a steadily increasing auction of allowances.67

66 67

The period simply needs to be long enough that the discounted value of the allowances lost in the future due to closure has a negligible present value. Similar approaches have been featured in recent allowance allocation proposals in the United States. For example, the original version of the Bush Administration’s “Clear Skies” proposal for the regulation of SO2 and NOx would have begun with free allocation and would have gradually increased the proportion of allowances auctioned over the course of 50 years until all allowances were auctioned. A recent proposal by the U.S. National Commission on Energy Policy for an economy-wide greenhouse gas trading program would begin with the auction of 5% of allowances for three years, and would then phase in an increase to 10% over the following ten years.

Chapter 4. A Framework for Emissions Trading in Korea 65

Chapter 4. A Framework for Emissions Trading in Korea

1. Policy Environment of Korea Korea is not listed in Annex B of the Kyoto Protocol and so does not have a quantitative emissions reduction target. Many actors in Korea, however, have great interest in the design and implementation of a national emissions trading system. The government has made efforts to design an emissions trading system for a pilot phase experiment. Industry representatives have been discussing a potential emissions trading system and have conducted some simulations. Research institutions have been analyzing the effects of various possible trading mechanisms.

1.1

Greenhouse Gas Emissions

The total greenhouse gas emissions in Korea were 542.67 Mt CO2 in 2001. The trend of total greenhouse gas emissions between 1990 and 2001 indicates an annual increase of 5.2% with per capita emissions rising by 4.3% per year, recording 11.48 tCO2 in 2001. However, greenhouse gas intensity, which increased during the early 1990s, began to fall after 1996. In the energy sector, which consists of fuel combustion and fugitive emissions, greenhouse gas emissions increased 5.6% per year from 247.87 Mt CO2 in 1990 to 452.83 Mt CO2 in 2001. After 1990, emissions from industrial processes recorded a sharp increase of 10.2% per year. The growth of greenhouse gas emissions will continue if efforts to reduce emissions are not implemented. Projections indicate that Korea’s greenhouse gas emissions will rise by 70% above 2000 levels by 2020. However, carbon intensity is expected to gradually decrease due to improvements in demand-side energy efficiency and shifts to cleaner fuels. Carbon dioxide, the main gas among energy-related greenhouse gases, will see an increase of 2.9% annually from 2000 to 2020 and account for 96.8% of all greenhouse gas

66


emissions in 2020 from the 93.5% in 2000. This implies that carbon dioxide is the most important greenhouse gas for the government to control to cope with climate change.

Table 4-1. Major indicators of Greenhouse Gas Emissions

Classification

Total GHG Emissions (1,000t CO2) Per Capita GHG Emissions (t CO2 per Capita) GHG/GDP (t CO2 per Million Won, ’95)

1990

1995

1998

1999

2000

2001

1990∼2001 Average Annual Growth Rate (%)

310,706

452,632

454,571

496,987

528,950

542,806

5.2

7.26

10.05

9.83

10.67

11.26

11.48

4.3

1.181

1.199

1.151

1.137

1.104

1.1

-2.2

Source: Republic of Korea (2003)

1.2.

Development of Greenhouse Gas Emissions Trading

The government has made efforts to design a greenhouse gas emissions trading system for a pilot phase experiment since the beginning of this millennium. The two major ministries, the Ministry of Environment (MOE) and the Ministry of Commerce, Industry and Energy (MOCIE), have sponsored various research and capacity building projects to prepare for the introduction of pilot phase emissions trading programme. After the adoption of the second “Comprehensive Plan to Combat Climate Change (CPCCC)” in 2002, a taskforce was organized under the supervision of the Prime Minister’s Office to coordinate the proposals from the two ministries, MOE and MOCIE, and to finalize and implement a pilot phase trading scheme.


MOE and MOCIE developed their proposals independently and submitted them to the taskforce for evaluation and coordination. The two proposals happen to be quite similar and employ the UK’s incentive auction as a core element.

Table 4-2. Proposals for Pilot Phase GHG Emissions Trading for Korea Proponent Implementation Period Gas Coverage

Source Coverage

Initial Allocation Baseline Emissions

Incentive Money Trade Regulation Banking Penalty Monitoring and Verification

Ministry of Environment

Ministry of Commerce, Industry and Energy

Preparation Period: 2004-05 Preparation Period: 2004-05 1st Implementation Period: 2006-08 st Implementation Period: 2006-08 1 2nd Implementation Period: 2008-10 2nd Implementation Period: 2009-11 3rd Implementation Period: 2010-12 1st Implementation Period: CO2 only 2nd Implementation Period: Six gases under the Kyoto Protocol 1st Period: Facilities with annual 1st Period: Electricity generators emission above 30,000 tCO2 (600 (28 units) units) nd Period: Energy intensive 2 2nd Period: Facilities with annual industries emission above 20,000 tCO2 Incentive auction 1st Period: Annual average 1st Period: Annual average emission during 2002-05 emission during 2004-05 nd Period: Annual average 2 2nd Period: Allocation for 2006-08 emission during 2006-08 1st Period: Korean Won 5 billion 1st Period: KR 10 billion nd 2 Period: KR 10 billion Up to 10 % of initial allowances can be traded before reconciliation Unlimited Financial penalty of twice the Excess emission offset for 130% of auction equilibrium price over-emissions A modified GHG Protocol (WRI) National inventory guidelines (to TMS and SODAM data be developed)

Since both proposals are based on voluntary participation and an incentive auction, no strong objection has been raised by industry. However, it has not been possible to develop a joint proposal, mainly because of conflict between the two ministries on the institutional leadership and the lack of financial sources for the auction. Several trading simulations have been conducted

68


jointly by research institutes and ministries with active participation by potential industry participants. These efforts seem to be useful for the education of industry participants and for analyzing the potential drawbacks of proposals. The government’s process to finalize the pilot phase trading rule, however, has been delayed many times in spite of increased public awareness on climate change. As of now, the taskforce under the Prime Minister’s Office is making efforts to design and to build capacity for a pilot phase emissions trading scheme, but its implementation might not be possible in near future.

1.3 1.3.1

Air Pollutant Emissions Trading in Seoul Metropolitan Area68 Background

The Republic of Korea faces serious air pollution caused by its dense population, as well as its energy-intensive industry structure. Emissions of particulate matter per unit area are five to ten times greater than those in the United States, France, Germany, or the United Kingdom. 69 Sulfur dioxide (SO2) emissions per unit area also are two to ten times greater than those of many OECD countries. Although per capita emissions are not excessive, the environmental burden is likely to exceed the natural carrying capacity. Moreover, the concentrations of air pollutants, such as fine particulates (PM10)70 and nitrogen dioxide (NO2), are the highest among the major cities in OECD countries. According to OECD (2002), the ambient concentration of PM10 in Seoul in 2002 was around 76 µg/m3, which was the highest among all the densely populated major cities with up to 5~10% of national total population. The NO2 concentration in Seoul was second highest after only Bratislava among the major cities reported in OECD (2002). Strong policy measures to tackle air pollution in the Seoul Metropolitan Area have been introduced. In December 2003, the Congress passed the Special Law on Improvement of Air Quality in Seoul Metropolitan Area (The Special Law, hereafter), initiated by the Ministry of Environment. The Special Law specifies principles for the responsibilities of governments, citizens and 68 69

70

Refer to Yoon (2005) for more information on the background and analysis of the trading scheme. Annual emissions of particulates per unit area (tonne/1,000ha) are about 42.19 for Korea, while they are 2.94, 3.83, 7.26 and 7.62 for the United States, France, Germany and the United Kingdom. Annual emissions of SO2 per unit area (tonne/1,000ha) are about 115.13 for Korea, while they are 18.24, 15.17, 23.30 and 48.63 for the United States, France, Germany and the United Kingdom. (KEI, 2004) Particulate matter with diameters smaller than 10 µg.


industries, procedures for the establishment and implementation of an air quality management plan, key policy instruments including emissions trading for major industrial sources, promotion of low-emission vehicles, an old car scrappage programme, subsidies for emission reduction equipment, and fuel information disclosure. Regulatory Orders and Implementing Rules, which include detailed implementation rules and guidelines, have been developed and promulgated at the end of 2004. (Republic of Korea, 2004; Ministry of Environment, 2004) These achievements are expected to provide an essential element for the development and implementation of emissions trading system for the first time in Korea, though there are a lot of challenges still to be overcome.

1.3.2

Targets and timetables

The Special Law specifies that a cap-and-trade programme shall be designed for SOx, NOx and Total Suspended Particulates (TSP)71 and applied for industrial sources with emissions above a level set by the government. The Special Law also specifies that the cap-and-trade programme shall be implemented from July 2007. Regulatory Orders and Implementing Rules, promulgated at the end of 2004, specify the applicability criteria (threshold level of emission) for participation and the time schedule. The level of the cap (target emissions under the cap-and-trade programme) and allowance distribution methodology are now under development. From the theoretical point of view, the emissions target (level of the cap) should be set so that the marginal abatement cost is equal to the marginal benefit from the reduced emissions. It is difficult, however, to determine such a level precisely due to the lack of information on marginal costs and marginal benefits. 72 A target reduction range, approximately 40 to 60%, over the ten-year planning period is under discussion. A study to assess technology options is underway. To determine which emission sources are to be included, the existing classification of emission sources under the Clean Air Act of Korea has been utilized. The Act categorizes emission sources into five groups according to 71 72

Because of the technical problems in monitoring PM10 emissions from facilities, TSP emission was selected as a proxy variable. Emissions of TSP are known to be proportional to emissions of PM10. The marginal costs and marginal benefits are likely to change over time, which increases the difficulty of trying to set the emissions cap precisely using this approach.

70


their emission quantities. ‘Category 1’ sources are defined as those sources with total air pollutant emissions exceeding 80 tonnes per year. The threshold levels for ‘Category 2’, ‘Category 3’ and ‘Category 4’ are 20, 10 and 2 tonnes per year. Larger sources, i. e., sources in a higher class, are subject to more rigorous regulatory rules, such as more frequent inspections and stricter standards for environmental management and emissions monitoring. The government and industry agreed to take advantage of this classification to avoid adding unnecessary complexity to the overall regulatory structure. It is deemed necessary, however, to modify the category definitions to reflect the fact that the cap-and-trade programme is designed to be applied pollutant-by-pollutant: there will be three emissions markets, one for each pollutant. Therefore a threshold level is set for each of the three pollutants. ‘Group A’, which corresponds to Category 1, is defined as the sources with emissions over 30 tonnes/year for NOx, 20 tonnes/year for SOx, or 1.5 tonnes/year for TSP. ‘Group B’, which corresponds to Category 2 and 3, is defined as the sources, not being classified as Group A, with emissions over 4 tonnes/year for NOx or SOx, or 0.2 tonnes/year for TSP.73 Under the Regulatory Orders (ROK, 2004) to the Special Act, the cap-and-trade programme will apply to ‘Group A’ sources from July 2007 and expand the coverage to ‘Group B’ sources in July 2009.

1.3.3

Allocation of emission allowances

Auctions are excluded from the feasible alternatives for allowance allocation in Korea, due to the severe financial burden on the regulated sources, which is not acceptable to industry. As concluded in Harrison and Radov (2002), grandfathering is a more efficient and more acceptable to industry, compared to updating. Consumers could benefit from updating, but only at the expense of a loss of efficiency. Considering the strong reduction target for the industries under the Air Quality Management Plan for Seoul Metropolitan Area, grandfathering seems to be a better choice.74 73

74

Based on data for year 2001, Group A sources, 0.9% of all sources, are responsible for 81% of NOx, 74.9% of SOx and 53.6% of TSP emissions from stationary sources. Group B sources, 1.1% of all sources, are responsible for 3.1% of NOx, 3.4% of SOx and 3.5% of TSP emissions. The simplicity of grandfathering is also an important advantage. US EPA (2003) emphasizes simplicity as one of the guiding principles, together with accountability, transparency, predictability and consistency: Simplicity is an important goal when designing an effective capand-trade program. Program operation for both emission sources and regulating authorities can be less costly and time-consuming if the rules are not overly complex or burdensome. Markets


KEI (2004) investigated four allocation methods of grandfathering, with different metrics and classifications. The first method is an input-based allocation with a single formula for all emission sources (input-based universal formula). The second method is an input-based allocation with differentiated formulas, one for each group of emission sources of the same facility type and of the same kind of fuel used (input-based facility/fuel-specific formula). That is, emission sources are classified into different groups according to the facility type and fuel used, and a different allocation formula is applied to each group of sources. The third method is an output-based allocation for each group of companies with similar products (output-based sector-specific formula). For example, an allocation formula based on kilowatt-hours of electricity produced is used for all the electricity generation facilities. The fourth alternative is an emission-based allocation with a single formula for all sources (emission-based universal formula). KEI (2004) proposed input-based facility/fuel-specific formulas (the second method above) for all sources except electricity generators combined with the output-based sector-specific formula (the third method) for electricity generators.75 It argues for such a hybrid approach in that electricity generators are the only sector to which an output-based allocation can be applied and that the other sectors should be dealt with due consideration for facility/fuel specific conditions. Facility-fuel specific application of input-based allocation can mitigate unfair compensation to over-consumption of energy by an input-based universal formula under which emission sources with a lower energy-efficiency get more allowances. The detailed allocation rule is under development and includes the development of a classification for a wide range of facility/fuel types. Regulatory Orders to the Special Law prohibit the use or transfer of allowances allocated to sources if they cease operation: allowances distributed initially to sources for a specific year are cancelled if the source does not operate its facility in that year (no shutdown credit). When a source ceases operation at some point during a year, only the share of allowances equal to the proportion of the year during which the source operated become valid.

75

function better when the rules are simple and easily understood by all participants. The South Coast Air Quality Management District (SCAQMD) in California has applied an Input-based facility/fuel specific formula for the RECLAIM (Regional Clean Air Incentives Market) program. The U.S. SO2 trading program (Acid Rain Program) has applied an input-based universal formula. The SO2 trading covers only the electricity sector and so the facility-specific approach may not have been given serious consideration.

72


The detailed methodology for allocation to new entrants has not yet been developed. The discussion in Section 4 (Treatment of closures and new entrants) of Chapter 3 tells us that we need to keep a balance between withdrawal from shutdown facilities and award allocation to new entrants. The regulatory authority may need to set aside some allowances for new entrants and establish emission rate benchmarks that are standardized across industry sectors, fuel types and technologies for allocation to new entrants. It is not only difficult, but also cannot avoid efficiency loss due to inevitable differences among existing facilities in the case of closures. That is, existing facilities face different levels of allowance withdrawals and an emission-intensive facility such as a coal-using power plant is likely to have higher opportunity costs of closure and therefore may have an incentive to continue to operate. To eliminate such imbalance of treatment among existing facilities in the case of their closure, the regulatory authority may need to set a uniform standard for withdrawal from closing facilities such as a single withdrawal rate per unit output of production, but it is much more of a difficult task to do. Additional design efforts, however, are indispensable for the successful implementation of emission trading schemes.76

1.3.4

Trading and banking

Regulatory Orders (ROK, 2004) and Implementing Rules (MOE, 2004) to the Special Law specify several constraints on the trading and banking of allowances. It limits the quantity traded to a fraction of the allowances allocated. In the first year, each source is not permitted to transfer more than 20% of its initial allocation. The limit increases to 30% in the second and third years and to 50% in the fourth and fifth years. Although it may lead to a loss of efficiency, the restriction on the quantity traded is intended to mitigate moral hazard (non-compliance due to over-selling) and adverse selection (over-supply of allowances by generous allocations due to information asymmetry).77 In addition, an allowance trade shall not be approved by the 76

77

An easier and more effective way to deal with this problem may be to revise the regulatory orders so that they allow shutdown facilities to sell their allowances and require new entrants to buy their allowances. The seller liability rule, where a buyer does not have any liability on non-compliance of a seller, is commonly applied to domestic or international emissions trading. Under the seller liability, however, the risk of over-selling could be high and a counter measure needs to be designed. In the climate change context, the Marrakech Accords (UNFCCC, 2002) requires Commitment Period Reserve (CPR) for trading Parties, under which each Party cannot sell above 90% of initial allowances or 100% of the verified emissions in the previous year.


affected provincial government if it violates the emission carrying capacity of the provincial area. This rule may help prevent regional hot spots. Even though banking is desirable for enhancing the efficiency of inter-period resource allocation, it needs to be constrained to a certain degree so that severe temporal hot spots can be prevented. The Regulatory Order to the Special Law limits the maximum level of banking to 10% of total allowances for the following year with discounting of 50% (two-for-one). If the sum of banked allowances exceeds 10% of total allowances for the following year, all the banked allowances are discounted proportionally so that the sum of banked allowances after discounting equals 10%. For the purpose of environmental effectiveness, two-for-one discounting is applied to the use of banked allowances, which effectively reduces the maximum level of banking to 5% of total emission allowances in the following year.

1.3.5

Penalties and incentives

The Special Law includes the provisions on a financial penalty and excess emission offsets. Regulatory Orders (ROK, 2004) and Implementing Rules (MOE, 2004) to the Special Law specify a penalty function similar to the existing one for violation of the emission standards. Under the Clean Air Act, the sources that emit beyond the standards pay a penalty based on the base rate (per unit of emission) multiplied by four factors: quantity of over-emission, coefficient for rate of over-emission, adjustment factor for change of price index and progressive coefficient for frequency of violation. Excess emission offsets are also specified by the Regulatory Order, which will strengthen the overall level of penalty for non-compliance. The offset ratio increases from 1.0 to 1.8 as the number of violations rises from 1 to 4 or more. A source that emits more than the allowances it holds for the first time must reduce the amount of over-emission in the next year. A source that over-emits for the second (third) time, must reduce 1.2 (1.5) times the over-emission in the next year. The offset ratio increases to 1.8 if the number of violations becomes four or more. The combination of excess emission offsets and a financial penalty should deter non-compliant behavior. Several incentives are provided to participants in the cap-and-trade system. First, financial assistance will be provided by the Ministry of Environment and local governments to the regulated sources if they install New Best Available

74


Technologies. Second, emission fees under the Clean Air Act (CAA) are not levied on regulated sources if they comply with the cap-and-trade rules. Last but not least, regulated sources are exempt from the fuel choice regulation under the CAA, so they have greater flexibility in decision-making and can improve the efficiency of resource allocation.

2. Policy Recommendations for GHG Emissions Trading in Korea 2.1

A Phased Approach

When and how to develop a greenhouse gas emissions trading scheme for developing countries is heavily dependent on the future climate change regime, particularly after 2012. When and how a developing country takes a legally-binding emissions limitation commitment might be the most important driving force for the design of a greenhouse gas emissions trading scheme. It is extremely difficult to anticipate the result of the negotiations on the post-2012 climate change regime. There is a huge range of scenarios for the post-2012 regime, particularly for developing countries. The commitment of a developing country might be similar to that of developed countries under the Kyoto Protocol, but it is more likely to take a flexible form such as voluntary commitment, (dual) intensity target, or sectoral credit mechanism, or a combination of these. Among the many dimensions of such commitments, the legal nature of the commitment, i.e., legally-binding or not, may be the most important factor that affects the design of an emissions trading scheme. Under the assumption that Korea will take a legally-binding emission limitation commitment at some time in the future, it may be helpful to distinguish between two stages: The pre-commitment stage is the period starting now and ending with the start of a legally-binding commitment; the commitment stage begins with the start of the commitment period for a legally binding obligation to reduce greenhouse gas emissions.78 78

The commitment stage can be defined more broadly so that it encompasses a situation under which the government commits to mandatory regulation on greenhouse gas emissions even


A phased approach needs to be designed to accommodate the difference between the two stages. A mandatory regulation may be required in the commitment stage while a voluntary scheme is more feasible and desirable in the pre-commitment stage. We first present our policy recommendations on the mandatory cap-and-trade system for the commitment stage in the next section and then suggest some possible voluntary schemes for the pre-commitment stage.

2.2

Commitment Stage

The emissions trading scheme for the commitment stage should be designed after in-depth analysis of various alternatives and an intense process of public consultation.79 It may be a cap-and-trade system or baseline and credit trading system, depending on the nature of the commitment and other policy environments. It might take very long time to prepare a detailed mechanism, but some basic principles or approaches need to be clear as soon as possible to avoid perverse incentives for industry and to promote rational decision-making for long-term investment. One of the most important principles that needs to be clear at an early stage is the basic approach to the initial allocation of allowances. As discussed earlier, there are many alternatives for initial allocation of emission entitlements: Grandfathering, updating, auction, and incentive auction. Each of these alternatives has different implications for the efficiency, financial burden, asset value, and decision-making environment of the affected industries. The impacts on strategic incentives and speculative decision-making of industries are of particular importance. The allocation method industry expects in the future policy heavily affects its behavior during the pre-commitment stage. For example, sources may increase, or at least not decrease, their emissions

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without an international legally-binding commitment. The arguments in this research remain valid with such a flexible definition. Other policy instruments, carbon taxes in particular, could be also conceived of as an alternative for the control of greenhouse gas emissions. When the international permit market works perfectly, taxes yield suboptimal results under uncertainty, whereas (domestic) emissions trading yield optimal results because emissions trading adjusts instantaneously to changes in international permit prices, whereas taxes require a government decision to change. In the other extreme case, when there is no international permit market, the marginal benefits (from greenhouse gas reductions) consist of the domestic environmental benefit, international favour from abatement, and the indirect effect of abatement on other countries’ emissions. If we assume that marginal cost is steeper than marginal benefit, the tax system is preferred to emissions trading. (Sin and Kerr, 2005)

76


before the start of emissions trading policy if they expect a free grandfathering allocation or incentive auction based on a period during the pre-commitment stage. Any signal for grandfathering from the government may harm voluntary efforts to reduce emissions and even incentivise intentional over-emission. An incentive auction, or any kind of baseline-and-credit mechanism, under which reductions are calculated relative to a specified baseline, may have similar consequences. Updating does not have such perverse incentives but it suffers from efficiency loss due to product market distortion. Auction seems to be the best method for initial allocation in a future emissions trading scheme. It does not provide a perverse incentive to not reduce emissions early and has the potential to attain maximum efficiency. The baseline protection problem, or compensation to early reduction efforts, can be avoided or be resolved most effectively under auctions. Many economists and theoretical analyses propose auctions as the best method of allocation. Cramton and Kerr (1998) conclude an auction is the best way to achieve carbon caps set by international negotiation to limit global climate change. They emphasize that an auction is preferred to grandfathering because it allows reduced tax distortions, provides more flexibility in distribution of costs, provides greater incentives for innovation, and reduces the need for politically contentious arguments over the allocation of rents. Another advantage of auctions is their compatibility with the “polluter pays” principle. One of the serious concerns with grandfathering is that it helps polluters make money and often results in windfall profits to polluters. While the revenue from an auction enables the government to reduce existing distortionary taxes, it can impose a large financial burden on affected industries.80 Estimates from the United States suggest that less than 20% of the revenue needs to be redistributed to participants to offset the cost of the trading programme.81 The percentage varies widely across industries and may depend on the stringency of the emissions cap.82 The redistribution to participants should not be in proportion to emissions 80

81 82

One way to reduce the financial burden is to allow successful bidders several months to pay for the allowances purchased. Participants will build compliance costs into their prices and operating decisions, and so should collect the cost of allowances over the course of the year. They can use the money collected/saved to pay for allowances purchased at the auction. See Bovenberg and Goulder (2000), U.S. Congressional Budget Office (2001), Bernard et al. (2001) and Smith and Ross (2002). A trading program also imposes costs on non-participants. So, reducing existing taxes in ways that benefit non-participants is reasonable.


or the incentive to reduce emissions is lost. That means some participants will be net winners. Obviously the losers will complain, so it will be difficult to get agreement on the appropriate redistribution. A redistribution tied to output might be challenged under WTO as a production subsidy. Generally, the most distortionary taxes faces by industry are those on labor (the costs to employers of hiring staff) and on capital. Reducing the taxes paid by industry on labor would benefit labor intensive industries, including those not covered by the trading programme, relative to emission intensive industries.83 Even though it is possible for the government to announce now that an auction will be used, industry may believe that it could lobby for a free allocation when the time comes regardless of what is announced now. It is also possible to announce now that a historic period, say 2002-2005, will be used as a future baseline, in the case that grandfathering allocation is applied, and so encourage early reductions. Considering that a stable price signal is more important than rigid quantitative control of emissions in the short term, some safeguards to prevent the risk of an extremely high price are warranted. A price cap and/or limited borrowing could be applied with appropriate international coordination. Unrestricted banking should be allowed to provide the maximum degree of flexibility. 84 It is necessary to link domestic trading programmes with international emission markets to promote the efficiency of global and domestic emission control. It is also important to ensure the widest possible coverage of sources to maximize the economic efficiency and environmental effectiveness of the trading programme. A wider range of emission sources facilitates the realization of potential welfare improving (i.e., cost reducing) transactions and minimizes emission leakage from affected sources to outsiders.

2.3

Pre-Commitment Stage During the period with no international regulation on greenhouse gas

83

84

This was an important problem when the Climate Change Levy was introduced in the UK under which employers’ health care costs were reduced by an amount equal to the projected revenue from the Levy. The experience of many programs when they are introduced is that emission reductions can be achieved at lower cost than anticipated. This leads to the accumulation of a relatively large bank of allowances, which creates uncertainty concerning future prices. An allowance life of a few years (2 to 5) limits the size of the bank and should be considered as part of the banking provision.

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emissions, it may not be possible to gain the political momentum needed to enforce a mandatory domestic cap-and-trade system. Voluntary or pilot phase incentive-based emissions trading schemes are more likely to be politically feasible. The policy objective of the government may not be to minimize costs subject to an emission quantity constraint, in the case of which a mandatory emissions trading could be the best solution. Rather, maximizing learning-by-doing and facilitating reduction efforts subject to a budget constraint may be the relevant policy objectives. Emissions trading with an incentive auction could be an alternative at this stage. The stability of aggregate reduction costs under uncertain costs may be an important advantage of incentive auctions. The policy goal with no legally-binding international obligation might be to facilitate maximum reduction efforts with a given budget or cost burden. How to link a domestic trading programme with the CDM is an important issue for developing countries. As a result of recent decisions by the Executive Board and COP/MOP-1, it appears that the implementation of an emissions trading programme for greenhouse gases could qualify as a CDM project. The CDM Executive Board (EB) and Conference of the Parties appear to support unilateral CDM. The Board has registered several unilateral projects. Major countries, including China and India, appear to have dropped their opposition to unilateral CDM. COP/MOP-1 decided that “a local/regional/national policy or standard cannot be considered as a clean development mechanism project activity, but that project activities under a programmeme of activities can be registered as a single clean development mechanism project activity provided that approved baseline and monitoring methodologies are used that, inter alia, define the appropriate boundary, avoid double counting and account for leakage, ensuring that the emission reductions are real, measurable and verifiable, and additional to any that would occur in the absence of the project activity”. This decision still needs to be interpreted by the Executive Board, but it appears to allow an emissions trading programme to be registered as a CDM project activity provided that the baseline, monitoring and other conditions are met. The emissions trading programme itself could not be a CDM project activity, but the emission reductions achieved by the participants of the emissions trading programme could qualify. The baseline for the CDM project would be the cap for the emissions trading programme and it would be


necessary to demonstrate that it is lower than the emissions would otherwise be. If the monitoring and other methodology requirements are met, it should be possible to earn CERs for net emission reductions from the baseline.85 The CDM Executive Board has decided (EB 22 report, Annex 3, 23-25 November 2005) that national and/or sectoral policies or regulations that give “positive comparative advantages to less emissions-intensive technologies over more emissions-intensive technologies (e.g., public subsidies to promote the diffusion on renewable energy or to finance energy efficiency programmes)” that have been implemented since the adoption of the CDM’s modalities and procedures by the Conference of the Parties (i.e. 11 November 2001) “may not be taken into account in developing a baseline scenario…”. This means that the baseline scenario for an emissions trading programme may refer to a hypothetical situation without national and/or sectoral policies or regulations to encourage emission reductions being in place. The possibility of the over-compensation of participants in incentive auction needs to be avoided. The UK incentive auction appears to have suffered from asymmetric information and possibly strategic behavior by the larger participants with the result that the incentives paid were too high. No information on the market price of allowances was available at the time.86 With an international market for CERs and the option for companies in a developing country to undertake CDM projects, the problem of lack of knowledge of the market price and asymmetric information is much reduced. The government could announce, for example, that it will not pay an incentive higher than the market price for CERs. Companies would still have an incentive to participate if the transaction costs were lower, which would probably be the case. The emissions trading initiative for conventional air pollutants in the Seoul Metropolitan Area of Korea provides a promising opportunity for greenhouse emissions trading. Since the monitoring and verification procedures are already in place, the incremental regulatory costs are very low or negligible. If we are to deal with various pollutants, a multi-pollutant trading scheme is 85 86

It is not clear whether CERs could be earned for the difference between the “business-as-usual” emissions and the cap for the emissions trading program. Other auctions have performed better, although they dealt with allowances rather than reduction commitments. The US SO2 auction has become more efficient over time – the price spread for successful bids has narrowed significantly and now is very close to the market price. A NOx auction in Virginia in 2004 achieved prices slightly above the market price. Except for the first SO2 allowance auction, market prices for allowances were available at the time of the auction.

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better since it is more efficient than separate regulatory regimes: Actions to reduce one pollutant can increase or reduce emissions of others and multi-pollutant trading addresses all emissions. The following table shows the number of firms and emissions quantities (and shares) by industry classification in the Seoul Metropolitan Area. Among 547 firms in the region, 30 electricity firms cover 42.5 - 66.1% of emissions of NOx, SOx or PM10. Although we have only emission data for conventional air pollutants, we can expect a similar trend in greenhouse gas emissions. The electricity sector might be a major component of any emissions market. Figure 4-1 shows also that a limited number of firms covers the lion’s share of emissions. The ten or twenty biggest firms cover more than 70 or 80 percent of emissions. This enables us to start with a small number of big emitters without significant loss of the effectiveness or efficiency of emission control.87

Table 4-3. Number of firms and emission quantities (kg/year) by industry classifications in Seoul Metropolitan Area Industry Classification Firms Agriculture and Agriculture 1 Forestry Mining of Metal Ores 1 Mining and Quarrying Mining of Non-metallic Minerals, 1 Manufacturing

87

Except Fuel Manufacture of Food Products and Beverages Manufacture of Tobacco Products Manufacture of Textiles, Except Sewn Wearing apparel Manufacture of Sewn Wearing Apparel and Fur Articles Tanning and Dressing of Leather , Manufacture of Luggage and Footwear Manufacture of Wood and of Products of Wood and Cork, Except Furniture; Manufacture of Articles of Straw and Plaiting Materials

NOx

SOx

PM10

2,975

4,540

76

17,756

51,825

1,196

45

0

0

30

1,059,421

1,230,992

28,066

1

2,993

2,537

50

84

603,564

1,270,358

21,116

1

2,362

2,731

26

18

113,503

139,832

3,031

5

143,717

112,156

484

The drawback is that a trading program with a relatively small number of participants, most of which are in the same industry, may experience little trading. The participants may choose to withhold surplus allowances from the market to gain advantage over their competitors in the product (electricity) market. Then the potential efficiency gains for emission reductions will not be realized.


Manufacture of Pulp, Paper and Paper Products Publishing, Printing and Reproduction of Recorded Media Manufacture of Coke, Refined Petroleum Products and Nuclear Fuel Manufacture of Chemicals and Chemical Products Manufacture of Rubber and Plastic Products Manufacture of Other Non-metallic Mineral Products Manufacture of Basic Metals Manufacture of Fabricated Metal Products, Except Machinery and Furniture Manufacture of Other Machinery and Equipment Manufacture of Electrical Machinery and Apparatuseses n.e.c. Manufacture of Electronic Components, Radio, Television and Communication Equipment and Apparatuses Manufacture of Motor Vehicles, Trailers and Semitrailers Manufacture of Other Transport Equipment Manufacture of Furniture; Manufacturing of Articles n.e.c. Electricity, Gas, Steam and Hot Water Supply

30

1,684,268

3,782,948

29,314

1

2,596

3,948

216

12

1,351,190

2,321,421

48,374

51

6,952,671

4,638,461

354,214

20

102,153

114,213

3,299

47

4,489,602

5,424,756

129,322

43

575,844

273,094

7,769

21

82,465

37,026

1,338

1

3,730

2,880

48

4

55,620

44,979

989

2

53,453

10,957

333

14

182,714

16,616

2,136

2

10,859

13

109

4

2,737

3,302

120

30

39,723,185

17,760,543

481,384

4

129,149

109,033

2,485

1

2,449

1

4

1 1

15,054 23,004

1,801 644

102 87

Supporting and Auxiliary Transport Activities ; Activities of Travel Agencies

1

38,314

1,073

146

Real Estate Activities

22

173,806

179,040

3,249

8

58,608

176,013

1,792

1

160,306

35,624

846

1

2,233

63

8

1

1,639

4,783

213

Electricity, Gas and Water Supply Construction General Construction Wholesale and Retail Retail Trade, Except Motor Vehicles and Motorcycles Trade Hotels and Restaurants Hotels and Restaurants Air Transport Transport Real Estate and Renting and Leasing Business Activities

Business Support Services Public Administration Public Administration and Defence; and Defence: Compulsory Compulsory Social Security Social Security Human Health and Veterinary Health and Social Activities

Work

Social Work Activities

82


Other Community, Repair and Personal Service Activities

Total

Sewage and Refuse Disposal, Sanitation and Similar Activities Other Services Activities

78

2,280,667

341,019

10,792

4 547

27,622 60,132,271

44,229 38,143,449

395 1,133,130


70,000 60,000 50,000 40,000 30,000 20,000 10,000

540

529

518

507

496

485

474

463

452

441

430

419

408

397

386

375

364

353

342

331

320

309

298

287

276

265

254

243

232

221

210

199

188

177

166

155

144

133

122

89

111

100

78

67

56

45

34

23

1

12

0

Cumulative number of firms

NOx(ton/year)

SOx(ton/year)

PM10(100kg/year)

Figure 4-1. Number of Firms and Cumulative Emissions

If a greenhouse gas emissions trading scheme is developed only for the Seoul Metropolitan Area, some companies may shift production from that area to another part of the nation or to another country. Considering that several big firms have production facilities in the Seoul Metropolitan Area and other parts of the country, particularly the electricity industry, such perverse incentives and corresponding emission leakage might be detrimental. An additional intensity regulation for participants in the emissions trading programme can deal with this problem: A source would be required to meet a baseline emission intensity target, as well as holding allowances equal to its total emissions, if it reduces its output over baseline output level.88 More specifically, whenever a source has an output level lower than its baseline output, it is required to hold allowances at more than an ‘intensity-guaranteeing emission level’, which is defined by multiplying its output by baseline intensity target, as well as its actual emission. If a firm’s emission intensity is above a pre-determined target, say base year emission intensity, it is not allowed to sell (or bank) extra allowances even though its 88

The baseline output level and baseline intensity target should be defined before the implementation of the trading scheme. One alternative way is to set the base year and set the baseline output level and baseline intensity target as the output level and intensity level in the base year.

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actual emissions are lower than the quantity of allowances allocated initially.89 And if such a firm is willing to sell or bank extra allowances, it should cancel additional allowances equal to the difference between the actual emissions and the quantity that makes its emission intensity equal to its baseline intensity.90

Emission

a

Baseline Emission (Assumed to be equal to initial allowances allocated

d

b c

Baseline Output

Output

Figure 4-2. Diagrammatic Explanation of Intensity Regulation under Emissions Trading

89

90

Since it is not certain how much a source emits and produces output before the end of the implementation period (or verification period), we can only require that a source should yield emission allowances equal to the amount of allowances allocated initially, if the source’s output is lower than the baseline output and its emission is lower than the allowances allocated initially. It is necessary to allow the trading of allowances without restriction during the implementation period to help the market function well. Such an emission leakage to outside regions is an important problem in any kind of regional or local implementation of environmental regulation. The emissions trading program for conventional air pollutants in the Seoul Metropolitan Area is not an exception. The regulatory authority needs to investigate the potential problems from such emission leakage and to devise some complementary measures to deal with the problems, possibly through the intensity regulation proposed in this research. Such a regulation could mitigate the potential problems of over-compensation through over-allocation to some existing facilities and therefore the restriction on trading of allowances could be eliminated effectively.


In Figure 4-2, assume that the initial allowances allocated are equal to the baseline emission and the intensity target is set equal to baseline emission divided by baseline output. Whenever a source emits more than the amount of initial allowances (vertical-hatched area in Figure 4-2) it should buy allowances until the amount of allowances equals its emission. (It should buy distance ‘a’ of allowances in Figure 4-2) The rule is same in this case as in an ordinary emissions trading scheme. When a source emits less than the amount of initial allowances, three cases occur: In the first case where a source produces output more than its baseline output (horizontally-dotted lined area), it can sell extra allowances (‘b’) over its emission and the rule is also the same as in ordinary emissions trading scheme. In the second case where a source produces output less than its baseline output and also its intensity is lower than the baseline intensity target (vertically-dotted lined area), it can sell extra allowances over its emission by the amount of the difference between its emission and its intensity-guaranteeing emission level. The amount of allowances it can sell is indicated by distance ‘c’ in Figure 4-2, while this is ‘c+d’ in the case of ordinary emissions trading. In the third case, where its emission is lower than its baseline emission but its intensity is higher than the baseline intensity target (blank area in Figure 4-2), it is not allowed to sell allowances even though it holds extra allowances over its emission. One other possibility to mitigate emission leakage is to require that surplus allowances cannot be sold or banked if actual output is less than the baseline output level. A source is not allowed to sell allowances in the vertically-dotted lined area in Figure 4-2, as well as in the blank area. This is much simpler than the above intensity regulation in that it suffices to set baseline output and to check the actual output level as a means of comparison, while the intensity rule needs to set both an baseline output level and a baseline emission (or baseline intensity) and to check which one of the four possible scenarios applies. This simpler regulation, however, may result in under-compensation for a source that reduces emissions much more than its reduction of production, i.e., improves emission intensity. Such a GHG emissions trading as a CDM project activity could be initiated or organized by the central or local government, or by private industry associations. The organizer needs to secure the financial resources to run an incentive auction. The organizer may seek financial investors for the project from international carbon funds such as the Prototype Carbon Fund or Annex I governments.

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Some capacity building initiatives deserve to be considered before the start of emissions trading. The voluntary (followed by mandatory) reporting and verification of a greenhouse gas emission inventory of individual facilities or sources would provide valuable experience and infrastructure for emissions trading. The government could provide an incentive/compensation for the reporting efforts of industries through a baseline protection mechanism under which industries have the right to choose those reported emissions as baselines in future regulation. Such an information policy also promotes voluntary reduction efforts.

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Chapter 5. Concluding Remarks

Emissions trading has emerged as a core policy instrument for controlling greenhouse gas emissions (GHG) internationally and domestically. With the entry into force of the Kyoto Protocol, the size of the carbon market is increasing rapidly, with the magnitude of project-based transactions reaching around 107 million tonnes of CO2 in 2004. The Kyoto allowance trading market will grow to a much larger scale when we enter into the commitment period under the Kyoto Protocol starting from 2008. Many countries have been developing and implementing domestic or local GHG emissions trading programmes. Denmark and United Kingdom started their own domestic emissions trading programme many years before and the European Union started its regional mandatory cap-and-trade programme (EU ETS) for GHG emissions control in 2005. Australia and Japan also have experienced GHG emissions trading and many other countries, including Norway, Canada, and the United States, are now finalizing their implementation plans for GHG emissions trading. Emissions trading helps lower the cost of reducing GHG emissions by way of coordinating reduction efforts through trading, which, theoretically at least, could achieve maximum efficiency of global reduction efforts. Existing trading mechanisms, including CDM and EU ETS, show a significant impact on economic decision-making in a wide range of areas so as to promote climate friendly investments and operations worldwide. In spite of the huge uncertainty of future climate policy, emissions trading is likely to play an important role in the future. The experience and performance of GHG emissions trading in the past, however, reveals a lot of problems and challenges. The most important issue might be related to the allocation of allowances for both existing facilities (ongoing or shutdown) and new entrants. The various methodologies implemented, such as grandfathering, intensity-based free allocation or incentive auction, have generated many serious loopholes, including adverse selection and emission leakages. The use of allowance auctions has been limited in practice, even though it is believed to be the best policy option by

Chapter 5. Concluding Remarks 89

academics. The harmonization and coordination of many regional/national trading schemes being developed and implemented independently seems to be also an essential task for international society to advance towards a coherent global market. The wise utilization of the CDM is also an important area for future work to get developing countries, as well as developed countries, involved. Based on our review and analysis of existing GHG emissions trading mechanisms, we suggest several policy directions on a framework for GHG emissions trading scheme in Korea. A phased approach is required to meet the unique policy environment of Korea: A voluntary emissions trading scheme in the pre-commitment stage and a mandatory cap-and-trade scheme in the commitment stage. For a mandatory GHG cap-and-trade scheme, the best way of allowance allocation seems to be an auction combined with recycling some, but not necessarily all, of the revenue to the participants. We find an auction the only way to avoid a lot of potential problems including baseline protection, compensation for early action, adverse selection, windfall profits to incumbents, entry barriers, negotiation complexity and many other equity and efficiency issues. In the pre-commitment stage, the CDM can be utilized as key driving force for developing countries to introduce a GHG emissions trading scheme. An incentive auction can be proposed as a potential CDM project. Considering the existing air pollutant cap-and-trade policy of Korea, a multi-pollutant cap-and-trade system covering GHG and conventional air pollutants for the Seoul Metropolitan Area may be a promising alternative for cost-effective GHG emissions trading in Korea. Such a multi-pollutant trading scheme also could be a unilateral programme-based CDM project activity. The regulation on mandatory reporting and disclosure of corporate GHG emissions is also a useful initial step towards the successful implementation of emissions trading. Based on the evaluation on GHG emissions trading schemes, we also find some policy implications on the future development of emissions trading for conventional air pollutants in Korea, which is planned to start in 2007. The regulatory authority needs to make clear how to allocate allowances to new entrants and also to keep the balance between the opportunity costs of reduction between potential shutdown facilities and new entrants. Under the current rule that does not allow shutdown credits, an equivalent level of

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allowances needs to be allocated to new entrants free of charge. Without such free allocations, new entrants may face a competitive disadvantage compared to existing facilities and so existing facilities may continue to operate longer than they do under an efficient solution. In addition, an intensity regulation might be needed to avoid emission leakage outside the area through a shift of production without additional reductions on the national scale. We believe our policy recommendations may be useful not only for Korea but also for a wide range of developing countries, since they are facing a similar policy environment as Korea, particularly in the case of climate change.

References 93

References Ahman, Markus, Dalla Burtraw, Joseph Kruger, and Lars Zetterberg, The Ten-Year Rule: Allocation of Emission Allowances in the EU Emission Trading System, Resources for the Future, Discussion Paper 05-30, June 2005. Aulisi, Andrew, Alexander E. Farrell, Jonathan Pershing and Stacy Vandeveer, Greenhouse Gas Emissions Trading in U.S. States: Observations and Lessons from the OTC NOx Budget Program, World Resources Institute, 2005. Bernard, Alain, Carolyn Fischer, and Marc Vielle, Is There a Rationale for Rebating Environmental Levies? Discussion Paper 01–31, Resources for the Future, Washington, D.C., October 2001. Bodansky, Daniel, International Climate Efforts Beyond 2012: A Survey of Approaches, Pew Center on Global Climate Change, 2004. Bosi, Martina and Jane Ellis, Exploring Options for “Sectoral Crediting Mechanisms”, OECD, 2005. Bovenberg, L.A., and L.H. Goulder, Neutralizing the adverse industry impacts of CO2 abatement policies: What does it cost? Working paper presented at the FEEMNBER Conference on Behavioral and Distributional Effects of Environmental Policy, Milan, Italy, 2000. Cramton, Peter and Suzi Kerr, Tradable Carbon Permit Auctions: How and Why to Auction Not Grandfather, Resources for the Future, Discussion Paper 98-34, May 1998. Department for Environment, Food and Rural Affairs (DEFRA), United Kingdom, The Framework for the UK Emissions Trading Scheme, 2001 Depledge, Joanna, Continuing Kyoto: Extending Absolute Emission Caps to Developing Countries, Building on the Kyoto Protocol: Options for Protecting the Climate, World Resources Institute, 2002. Electric Power Research Institute (EPRI), The EU Emissions Trading Scheme: Key Issues and Future Outlook, December 2004. Environmental Finance, May 2005. Gilbert, Alyssa, Jan-Willem Bode and Dian Phylipsen, Analysis of the National Allocation Plans for the EU Emissions Trading Scheme, ECOFYS UK, August 2004. Haites, E., Output-based allocation as a form of protection for internationally competitive industries, Climate Policy, Vol. 3, Supplement 2, S29-S41, December 2003. Harrison, David, Jr. and Daniel B. Radov, Evaluation of Alternative Initial Allocation Mechanisms in a European Union Greenhouse Gas Emissions Allowance Trading Scheme, National Economic Research Associates, prepared for DG Environment of European Commission, 2002 International Emissions Trading Association (IETA), Greenhouse Gas Market 2004: Ready for Take-off, December 2004. International Institute for Sustainable Development (IISD), Earth Negotiations Bulletin, Summary of the UNFCCC Seminar of Governmental Experts: 16-17 May 2005.

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Kim, Yong-Gun, Erik F. Haites, Steve Sorrell, Tae Yong Jung, Poul Erik Morthorst, Myung Kyoon Lee and Jong Soo Lim, Domestic Greenhouse Gas Emissions Trading Schemes, Korea Environment Institute / UNEP RISO Center / Institute for Global Environmental Strategies, 2003. Korea Environment Institute (KEI), Air Quality Management Plan for Seoul Metropolitan Area, Ministry of Environment of Korea, 2004. (in Korean) Kroger, K., A qualitative study of the direct entry UK emissions trading scheme, a report by Enviros Consulting, London, 2003 Kruger, Joseph and William A. Pizer, The EU Emissions Trading Directive: Opportunities and Potential Pitfalls, Resources for the Future, Discussion Paper 04-02, April 2004. Lecocq, Franck and Karan Capoor, State and Trends of the Carbon Market 2005, International Emissions Trading Association / World Bank, May 2005. Oberthur, Sebastian and Hermann E. Ott, Framing Climate Policy Beyond Kyoto: Looking Back to Move Forward, Climate Policy for the 21st Century: Meeting the Long-term Challenge of Global Warming, Center for Transatlantic Relations, 2004 OECD, OECD Environmental Data Compendium 2002, 2002 Oxera, CO2 Emissions Trading: How will it affect UK industry?, prepared for Carbon Trust, July 2004. Pew Center on Global Climate Change, The European Union Emissions Trading Scheme (EU-ETS) Insights and Opprotunities, 2005. PointCarbon, Carbon Market Europe, June 24, 2005. Reinaud, Julia, Industrial Competitiveness under the European Union Emissions Trading Scheme, IEA Information Paper, December 2004. Republic of Korea (ROK), Special Law on Improvement of Air Quality in Seoul Metropolitan Area, 2003 (in Korean) Republic of Korea (ROK), Regulatory Orders to the Special Law on Improvement of Air Quality in Seoul Metropolitan Area, 2004 (in Korean) Rosenzweig, Richard, Dirk Forrister and Rob Youngman, A Paper on European Greenhouse Gas Performance, the European Union Emissions Trading Scheme, and Technology Policy, prepared for the TransAtlantic Conference on Energy Policy, NATSOURCE LLC, March 28, 2005. Sin, Isabelle and Suzi Kerr, with Joanna Hendy, Taxes vs Permits: Options for Price-Based Climate Change Regulation, New Zealand Treasury Working Paper 05/02, March 2005. Smith, Anne E. and Martin T. Ross, Allowance Allocation: Who Wins and Loses Under a Carbon Dioxide Control Program?, Charles River Associates prepared for the Center for Clean Air Policy, Washington, D.C., February 2002. Sorrell, Steve, The UK emissions trading scheme, Domestic Greenhouse Gas Emissions Trading Schemes, Korea Environment Institute / UNEP RISO Center / Institute for Global Environmental Strategies, 2003. Special Committee on a Future Framework for Addressing Climate Change, Sustainable Future Framework on Climate Change (Interim Report), Global Environmental Sub-Committee, Industrial Structure Council, Japan, December 2004. United Nations Environment Programme (UNEP) / International Emissions Trading Association (IETA), Carbon Market Update, May 2005.

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United States Congressional Budget Office, An evaluation of cap-and-trade programs for reducing U.S. carbon emissions. U.S. Congressional Budget Office, Washington, DC, 2001. United States Environmental Protection Agency (US EPA), Tools of the Trade: A Guide to Designing and Operating a Cap and Trade Program for Pollution Control, June 2003. Watson, Clinton, John Newman, Rt Hon Simon Upton and Petra Hackmann, Can Transnational Sectoral Agreements Help Reduce Greenhouse Gas Emissions?, Round Table on Sustainable Development, OECD (SG/SD/RT(2005)1)), 1-2 June 2005. Yoon, Suh Sung, Emissions Trading for Air Pollution Control in Seoul Metropolitan Area, KCESRI-OECD Join Seminar on Korean Economic Issues, Korea Council of Economic & Social Research Institutes, February 2005.

Abstract in Korean 97

Abstract in Korean

국제 배출권 거래, 청정개발체제(Clean Development Mechanism: CMD), 공동이행 등 3대 교토 메커니즘, 유럽연합(EU)의 배출권 거래제, 영국, 일본, 호주의 배출권 거래제, 그리고 미국과 캐나다에서 추진중인 배출권 거래제 등 전세계적으로 다양한 온실가스 배출권 거래제도가 시행되었거나 추진되 고 있다. 온실가스 배출권 거래제도는 기후변화 대응을 위한 정책적 노력에 서 점차 핵심적인 수단으로 자리잡고 있으며, 특히 EU 배출권 거래와 CDM 은 광범위한 분야에서 기후친화적인 투자를 촉진하는데 의미있는 역할을 하 고 있는 것으로 평가된다. 하지만 온실가스 배출권 거래제도는 초기 할당에 관련된 형평성 문제, 다양한 제도간의 연계, 기존 환경정책수단과의 조화 등 여전히 해결해야 할 많은 어려운 문제들을 안고 있다. 본 연구는 현재 전세계적으로 진행중인 온실가스 배출권 거래제도에 대 한 분석 및 비판적 평가와 함께 우리나라의 온실가스 배출권 거래제도 도입 방향에 대한 시사점을 제시하고 있다. 특히 국제적인 온실가스 감축의무를 부담하고 있지 않는 상황을 고려할 때 우리나라는 자발적 참여방식(의무부 담 이전단계)에서 출발하여 강제적 총량규제(의무부담 이후단계)로 이행하는 단계적 접근방식이 바람직하다고 판단된다. 의무부담 이전단계에서의 온실가스 배출권 거래제도는 CDM 사업과 연 계하여 추진하는 것이 바람직하다. 제18차 CDM 집행이사회(2005. 2월) 및 제1차 교토의정서 당사국총회(2005. 12월) 결정에 따라 프로그램 형태의 개 도국 단독(Unilateral) CDM이 허용되게 되었으며, 이에 따라 국내 온실가스 배출권 거래제를 통한 감축효과를 CDM 크레딧으로 인정받을 수 있다. 따 라서 국내 배출권 거래제의 CDM 사업화를 통해 배출업소에 대한 거래제 참가 인센티브를 제공함과 동시에 국제 온실가스 감축노력에 기여하는 효과 를 거둘 수 있다. 국제적 감축의무를 부담하게 될 경우 강제적 총량규제 및 배출권 거래제 의 도입이 불가피할 것으로 전망되는데, 이 경우 초기 배출권은 경매를 통 해 유상으로 배분하는 것이 바람직하다. 과거 배출량 등에 기초한 무상배분 방식(Grandfathering)은 다배출업소에 과도한 보상을 하게 되는 결과를 초래 함은 물론 신규 시설에 대한 차별, 소모적인 협상에 따른 시간과 자원의 낭 비 등 다양한 문제점을 초래함으로 바람직하지 않다. 무엇보다 이러한 점을

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악용하는 기업이 사전에 배출을 늘리고 오히려 자연발생적 감축효과에 대해 크레딧을 요구하는 폐해가 우려된다. 따라서 정부 차원에서 미래의 배출권 할당시 오염자 부담원칙에 충실한 경매제도의 적용의지를 가급적 조기에 천 명하는 것이 불필요한 사회적 갈등을 해소하는 데 바람직하다고 판단된다. 또한 2007년 시행예정인 수도권 대기오염물질 배출권 거래제도와 온실가 스 배출권 거래를 연계하여 실시할 경우 추가적인 행정비용과 중복규제를 최소화하면서 정부와 기업 모두의 효율성을 극대화할 수 있을 것으로 판단 된다. 단, 수도권에 국한하여 배출권 거래제를 시행할 경우 수도권 이외 지 역으로의 배출량 누출(Leakage effect)을 예방하기 위해 원단위 기준(원단위 감소시에만 배출권 판매 허용)을 병행하여 적용할 필요가 있다. 또한 온실가 스 배출권 거래제도의 도입 기반 확충을 위해 기업 온실가스 배출량 보고 및 공개제도를 먼저 도입하는 것이 바람직하다고 판단된다.